Stocks For The Long Run: Book Notes

This post contains my personal notes and reflections from the book: “Stocks for the long run: 5th edition” by Jeremy Siegel

1. Today’s globalised world warrants higher P/E ratios than in the past. But higher P/E ratios means that average returns in the future are going to be lesser than what they were in the past. But no matter what, stocks will remain the best investment for those seeking steady long-term gains. Why? Equities have to outperform bonds in the long run if our capitalist system is to survive. Bonds are contracts enforceable in the court of law. Equities promise the owners nothing; they involve a high degree of faith in the future. Since they are riskier, they have to have a higher expected return. If the long-term return on bonds were higher than that of equities, then they would priced so that risk will earn no reward. If that happens, the capitalist system will die.Therefore, stocks have been and will remain the best investment for all those seeking long-term gains. Yes, events like the financial crisis of 2008 may test our belief in this, but if we persist, then we will definitely be rewarded.

2.Investing over time in stocks has been a winning strategy whether one starts an investment plan at the market top at not. Even if you had started investing regularly in 1929 when the great stock market crash happened, over the long run( 30 years and above), you would have outperformed all other asset classes.

3. The total real and nominal returns from 1802-2012 for various asset classes are as follows. Total return is capital gains+ reinvestment of interest or dividends back into the same asset class.

  • Stocks: 6.6%(real), 8.1%( nominal)
  • Bonds: 3.6%(real), 5.1%(nominal)
  • Bills: 2.7%(real), 4.2(nominal)
  • Gold: 0.7%(real), 2.1%(nominal)
  • US Dollar: -1.4%, 1.4%(nominal)

4. Stocks have the behaviour of mean reversion: periods of above average returns tend to be followed by periods of below average returns and vice versa. In the short run, stock returns are very volatile driven by earnings, interest rates, risk, uncertainty, optimism, pessimism, fear and greed. But in the long run, they always move upwards. But in the short or even medium term, there can be bumps, even what may be seen as serious ones.

5. Leverage, if not properly employed hurts ultimately. A modern passenger car is safe than one built 50 years ago. But that does not mean the automobile is safe at any speed. A small bump on the road can wreak havoc to the best car. So be careful of  excessive leverage in all forms.

6. In a financial crisis, there is increased correlation among the world stock markets, but on a longer term, the correlations are still low. Therefore it is prudent to diversify when investing for the long-term.

7. No asset class can stay permanently detached from fundamentals, whether it is stocks or bonds.

8. The world is more globalised( in terms of work and who earns and who saves and who consumes) than ever and innovation and invention will continue to happen. Hence it is likely, that over the long run, equities will give us similar historical returns as in the past.

9. If you invest in the stock market and reinvest the dividends and never touch the capital, you can accumulate a lot of wealth. But we always accumulate less, because we spend the dividends or the asset itself. Very few have the patience to wait for generations.

10. Gold hedges inflation but does little else. If you constantly hold gold in your portfolio, your returns are likely to suffer.

11. Although most of the data we have concerns the US stock market, similar findings that stocks outperform bonds over the long run have been shown in many world markets. If we have to believe that capitalism will exist, then stocks should offer the best long-term returns.

12. In the short run, bonds or even bank accounts can outperform stocks. In the long run, stocks usually beat bonds by a great margin. In the long run, investment in stocks also maintain their purchasing power. So, stocks are the best investment for the long run.

13. % of time stocks beat bonds:

  • Over 1 year: 60% 
  • Over 2 year: 60%
  • Over 10 years: 80%
  • Over 20 years:90%
  • Over 30 years: almost 100%

14. All the major stock market indices can be replicated by investors. Therefore there is no statistical reason to believe that these indexes give a biased representation of the return on the market.

15. An investor who purchased the original S&P 500 firms and never bought any of the other firms would have outperformed the updated index over the last 50 years.

16. The tax advantage of equities over bonds is greater over long periods of investment.

17. The price of any stock is always equal to the present value of all future dividends and not the present value of future earnings. Earnings not paid to the investor as dividends can have value only if they are paid as dividends or cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of the firm.

18. Gordon dividend growth model: 

Price = Dividend per share/ Required return on equity – Rate of growth of future dividends per share

Required return on equity = Risk free rate + Expected rate of inflation + equity risk premium

19. Operating earnings are more important than reported or GAAP earnings.

20. Earnings yield on stocks is a real yield and should match the average real return that shareholders receive for holding equities.

21. Valuation is useful and one can use many methods. But it is not infallible. For who knows what the future brings. For most of us, holding a diversified portfolio should do just fine.

22. Over the long run: Small stocks outperform long stocks. Value stocks outperform growth stocks. The 100 highest dividend yielders in the S&P 500 outperform the S&P 500. The ten highest yielding Dow stocks also gives a good return.The ten highest yielding stocks from the largest 100 of the S&P 500 stocks also gives a good return. The 100 stocks with the lowest P/E ratio in the S&P 500 outperform the S&P 500. Stocks with lower liquidity outperform those with higher liquidity. IPOs generally underperform.

23. Only investors with a fully diversified world portfolio will be able to reap the best returns with the lowest risk.

24. Stocks are not good hedges against inflation in the short run. In the long run, they are a very good hedge against inflation.

25. You cannot beat the stock market by analyzing real economic activity. Nobody has done it so far.

26. World events may shock the market in the short run but they have been unable to dent the long-term returns that have become characteristic of stocks over the long run.

27. Strong economic growth invariably raises interest rates, but it has an ambiguous effect on stock prices, especially in the late stages of an economic expansion as higher interest rates battle against stronger corporate profits. Higher inflation is bad for both the stock and the bond markets. Central bank easing is very positive for stocks and can lead to good stock rallies. But these are all in the speculator’s realm. Most investors will do well to watch from the sidelines and stick to an investment strategy for the long run.

28. When the market is falling, it is wise to buy more, if you are holding for the long term.

29. Moving average strategies often do not work because of many whipsaws. Short term momentum strategies may work if the costs are low enough and you have to take into account taxes and slippage.

30. Stocks that performed poorly over the previous 3-5 year period significantly outperformed those that had done well over the previous 3-5 year period.

31. Calendar anomalies are not reliable and probably worth the trouble.

32. Futures and options have helped the stocks to be more liquid but are not a good way to get rich over the long run.

33. Precommit yourself to an investing plan and follow it.

34. If you invest when there is a lot of bad sentiment and stocks are falling, you will usually do well over the long run.

35. The best bet is to invest in capitalisation weighted or fundamentally weighted index funds.

36.The following are guides to successful investing:

  • Keep your expectations moderate. Over the long run equities have returned 6-7% after inflation and sold at an average P/E ratio of 15.
  • For long-term investment, invest in stocks.
  • Invest mostly in low-cost stock index funds.
  • Keep at least 1/3rd of your portfolio in non-US stocks.
  • Value stocks have given better return than growth stocks. So overweight value stocks.

36. You can try to pick hot stocks and hot mutual funds. You can market time. You will usually fail. The best bet is to diversify widely and invest for the long run. If you do that, you will be financially comfortable.

300 Little Reminders Of What Matters Most

Read a few of these reminders everyday. They will help you keep on track with regards to what matters most.

  1. A bold start is half the battle.
  2. Be somebody’s hero.
  3. Speak your mind.
  4. Any place with a shortcut is not worth going to.
  5. Try and fail, but don’t fail to try.
  6. Simplify life.
  7. Know what you want.
  8. Be trusting… but not naive.
  9. Show up.
  10. Know what you will and won’t do.
  11. Don’t be a perfectionist.
  12. Sing your own song.
  13. Keep your cool.
  14. Be amazing.
  15. An apology is a good way to have the last word.
  16. Finish what you start.
  17. Discuss ideas, not people.
  18. Approach a problem from many different directions.
  19. Think long-term.
  20. Be there for your friends.
  21. Live large.
  22. Increase your heart beat.
  23. Embrace change.
  24. Bounce back.
  25. Don’t confuse the tried with the impossible.
  26. Losers see barriers, winners see hurdles.
  27. Whatever you are be a good one.
  28. Make a deadline for your dreams, and they become goals.
  29. Keep your chin up.
  30. Take calculated risks.
  31. All obstacles are imaginary or temporary.
  32. There’s a smile right under your nose. Use it.
  33. Plan your work. Work your plan.
  34. When things go wrong, don’t go with them.
  35. Keep an open mind.
  36. Bring something to the table.
  37. Dare to fail.
  38. Welcome criticism.
  39. Take charge of your own destiny.
  40. Improve something.
  41. Lose your emotional baggage.
  42. Don’t always act your age.
  43. Pursue your passion.
  44. Know that you are unique.
  45. Labour and wait.
  46. Treat yourself kindly.
  47. Happiness is an inside job.
  48. Remove failure from your vocabulary.
  49. You only run out of chances when you stop taking them
  50. Stay curious.
  51. Find a way or make one.
  52. Whenever you fall, pick something up.
  53. Seize the day.
  54. It always seems impossible until it’s done.
  55. Make haste slowly.
  56. Disagree without being disagreeable.
  57. Kindness like a boomerang, always returns.
  58. Arguing with a fool proves there are two.
  59. Don’t be a yes man.
  60. The secret of success is to work only when you do.
  61. Trust the universe.
  62. If you have hope, you have everything.
  63. Overnight success usually takes about 25 years.
  64. Get mad, then get over it.
  65. There’s no elevator to success, only the stairs.
  66. Break the impossible down into possibilities.
  67. Raise a hand, don’t point a finger.
  68. Experience is a great teacher. Don’t skip her classes.
  69. Enjoy the moment.
  70. Listen thrice, think twice, speak once.
  71. Cultivate patience.
  72. Don’t rest on your laurels.
  73. Say something nice or say nothing.
  74. Put your future in good hands: your own.
  75. Be a part of something bigger than yourself.
  76. Find a need and fill it.
  77. Pull your own weight.
  78. Good is not good enough. Great is.
  79. Never underestimate your own power.
  80. Do something that scares you.
  81. Satisfy need, not greed.
  82. Love with abandon.
  83. Invest in yourself.
  84. Keep on keeping on.
  85. Value quality over quantity.
  86. The only helping hand you need is at the end of your arm.
  87. Stand up for yourself.
  88. Always be a little kinder than necessary.
  89. Be the last to fight, and the first to make up.
  90. Forgive and forget.
  91. The best way out of a problem is through it.
  92. Enjoy the journey as much as the destination.
  93. Make your day count.
  94. Don’t attempt to please everybody.
  95. Get up, dress up, show up.
  96. Make things happen, don’t wait for things to happen.
  97. Build castles in the air and then build them foundations.
  98. Fish where the fish are.
  99. Look for the best in people.
  100. All it takes is all you’ve got.
  101. Dream it, then do it.
  102. Pause if you must, but don’t stop.
  103. Be moderate in everything.
  104. Try something.
  105. Have an attitude of gratitude.
  106. When you get to the end of your rope, make a knot and hang on.
  107. Know the difference between money and wealth.
  108. Dream.
  109. Fix what you can, forget what you can’t.
  110. Don’t wait for change. Create it.
  111. Pain is inevitable. Suffering is optional.
  112. Think with your head, act with your heart.
  113. Do your best.
  114. You can’t direct the wind, but you can adjust the sails.
  115. Either you run the day or the day runs you.
  116. Make peace with the past.
  117. Do good and forget it.
  118. Have a sense of humor.
  119. Treat opposition like a kite treats the wind.
  120. Take one day at a time.
  121. Waste less, want less.
  122. Keep learning.
  123. Make more opportunities than you find.
  124. See the forest. See the trees.
  125. Keep growing.
  126. Slow down, and the things you’re chasing will catch up with you.
  127. Be your own best friend.
  128. Don’t judge yourself through someone else’s eyes.
  129. Take fun seriously.
  130. Put your money where your mouth is.
  131. Make big plans and stick with them.
  132. Love life, and life will love you back.
  133. Play nice.
  134. Rise above the little things.
  135. Walk the talk.
  136. Make happiness a habit.
  137. Don’t let what you can’t do interfere with what you can.
  138. Ignore the cynics.
  139. Value health over wealth.
  140. If you want to be happy, make others happy.
  141. Know where you are going.
  142. Don’t stop climbing when you have reached the top.
  143. Stop wishing, start working.
  144. Think of problems as opportunities in disguise.
  145. Be slow to take offense.
  146. Cooperate more, compete less.
  147. Hear everyone out, but listen to a chosen few.
  148. Do the difficult first.
  149. Take no one for granted.
  150. Stretch yourself.
  151. Do nothing half-heartedly.
  152. Step out of your own shadow.
  153. Don’t pick the convenient over the right.
  154. Go the extra mile.
  155. Forget the spilled milk.
  156. Celebrate small successes.
  157. Resist the path of least resistance.
  158. Turn your ‘shoulds’ into ‘musts’.
  159. Stick to one thing until you get there.
  160. Make your life a work of art.
  161. The truth hurts only if you run away from it.
  162. You can’t shake hands with a clenched fist.
  163. Let go.
  164. Are you listening or waiting to speak?
  165. Strangers are friends we haven’t met yet.
  166. Make your own luck.
  167. Let your work speak for itself.
  168. Know your own worth.
  169. Don’t stop to think if you are happy, and you will be.
  170. Be here now.
  171. Think of failure as feedback.
  172. Live within your means.
  173. Don’t look back and ask why. Look forward and ask why not.
  174. Start the day with a plan.
  175. Tell the truth. It’s easier to remember.
  176. Mean what you say.
  177. Move with the times.
  178. Say it to their face or not at all.
  179. Help others succeed, and you will too.
  180. Compete only against yourself.
  181. Don’t neglect the small things.
  182. Make time for daydreams.
  183. Lay a firm foundation with the bricks others throw at you.
  184. Try anything once.
  185. Question everything.
  186. Love someone too much.
  187. Unclutter your life.
  188. Start and end your day with gratefulness.
  189. Raise the bar.
  190. Destroy your enemies by making them friends.
  191. Zig when others zag.
  192. Be unafraid of the unknown.
  193. Resist the ordinary.
  194. Take the difficult way out.
  195. Travel light through life.
  196. Don’t ask for lighter burdens. Ask for broader shoulders.
  197. Put your heart into whatever you do.
  198. Each day is a gift. Be grateful. Be useful.
  199. Plan ahead.
  200. Be yourself. Everybody else is already taken.
  201. The shortest answer is doing.
  202. Make the most of what you’ve got.
  203. Focus fiercely on a few things.
  204. Do it well or not at all.
  205. Ask more of yourself.
  206. Get up one more time than you fail.
  207. Pay yourself first.
  208. Aim for awesomeness.
  209. Don’t wait for everything to be perfect.
  210. The harder you work, the luckier you get.
  211. Be better today than you were yesterday.
  212. Look for common ground.
  213. Pressure makes diamonds.
  214. Make the most of your talents.
  215. Don’t worry about things that haven’t happened yet.
  216. Create your future.
  217. Find your own voice.
  218. Celebrate what you want to see more of.
  219. Create more, criticize less.
  220. Never look down on somebody unless you’re helping him up.
  221. Be willing to be lucky.
  222. Rule yourself and you can rule anything.
  223. Have a wishbone, a backbone and a funny bone.
  224. You must lose a fly to catch a fish.
  225. Work on happiness.
  226. Be a self-starter.
  227. Hold a true friend with both your hands.
  228. Rise determined, sleep satisfied.
  229. Don’t be afraid of failing, only of trying.
  230. Go with your gut.
  231. A good friend is cheaper than therapy.
  232. Make someone else the center of your universe.
  233. If you learn from a mistake, it’s not one.
  234. Take everything with a grain of salt.
  235. Get what you want, want what you get.
  236. Let no one make up your mind for you.
  237. Expect the best and you’ll get it.
  238. Cut yourself some slack.
  239. If not now, then when? If not this, then what?
  240. Be new or be through.
  241. Happiness is a direction, not a destination.
  242. Walk in someone else’s shoes.
  243. Do what you love, love what you do.
  244. Cherish those who tell you the truth.
  245. Don’t be fooled twice.
  246. Know your mind.
  247. Attempt the impossible.
  248. Give up the need to be right.
  249. Tell your loved ones that they are loved.
  250. Lose not your sense of wonder.
  251. Promise less, perform more.
  252. You can curse the darkness or you can light a candle.
  253. Listen to your inner voice.
  254. Give everyone a second chance.
  255. Enjoy what you’ve got.
  256. Have high standards.
  257. You are stronger than anything that can happen to you.
  258. Make time for yourself.
  259. Be bigger than your circumstances.
  260. The best things in life are not things, like love, health, family and friends.
  261. Don’t fit in. Stand out.
  262. Go the distance.
  263. Leave everything a little better than you find it.
  264. Stick your neck out.
  265. Do what people say you cannot do.
  266. Anger is one letter short of danger.
  267. Improvement begins with “I”.
  268. Don’t be afraid to be vulnerable.
  269. Bait good luck with hard work.
  270. Let your faith be bigger than your fear.
  271. Ignore the rain. Look for the rainbow.
  272. Treat negativity like the duck treats water.
  273. Only a mousetrap has free cheese.
  274. Fall in love and stay there.
  275. Don’t let success go to your head or failure to your heart.
  276. Hold no grudges.
  277. Throw yourself into whatever you are doing.
  278. Don’t let failure defeat you.
  279. Even the longest day is only 24 hours.
  280. The future is always beginning now.
  281. Take yourself less seriously.
  282. Don’t bury your feelings.
  283. Give it all you have got.
  284. Measure twice, cut once.
  285. Come back stronger.
  286. Never be too busy for those who love you.
  287. Be somebody.
  288. Attitudes are contagious. Are yours worth catching?
  289. Ask the right questions.
  290. Go one step at a time and you can go anywhere.
  291. Let go gracefully.
  292. Don’t think too much about what others think.
  293. Use time wisely.
  294. Be lavish with praise and sparing with criticism.
  295. Choose comfort over style.
  296. Leave room for happy accidents.
  297. Have high expectations.
  298. Work like the place belongs to you.
  299. Expect miracles.
  300. Today is the first day of the rest of your life.

- from the book ” Things we forget by JJ Penn”

Asset Rotation by Matthew P. Erickson: Book Notes

This post contains my personal notes from the book Asset Rotation by Matthew Erickson. 

The text in bold are my viewpoints and reflections.

1. It is important to avoid prolonged declines in the investment markets to avoid significant losses. Buy, hold and pray will not prevent prolonged declines. Therefore a rotational approach to investment is better than ” buy and hold”. But remember that multi-asset class portfolios with proper proportion of bonds have withstood the test of time when you use short-term bonds.

2. In the current era of low-interest rates, bonds are not safe because an increase in interest rates will lead to price declines in bonds. The greater the maturity of bonds, the greater the price decline. Who knows?

3. Better active managers for long duration are very rare. So you cannot depend on better active managers to get you better returns. That is why you should invest in index funds.

4. Investing in individual stocks is also risky and not recommended for most investors. Yes, that is true but you can invest in index funds.

5. A simple strategy of asset rotation can yield better returns over the long run. Yes it can, but can it after accounting for slippage, trading costs and taxes.

6. Consider this simple strategy: Take 2 asset classes: S&P 500 and long-term government bonds. Buy the asset class which was up the most the previous month. If S&P 500 was up the most the previous month, we will buy S&P 500 and hold it for the next month and vice versa. The returns for this strategy from 1929 to 2012 has been 8.89% annualised return for the asset rotation and 8.96% for S&P 500 buy and hold. The returns for the asset rotation strategy have lower drawdowns compared to the S&P 500 buy and hold. Yes, timing lowers drawdowns, we all know that. But what would have been the return after accounting for trading costs, slippage and taxes. A lot lower.

7. The other strategy the author talks about is sector rotation with the 9 major sectors of the S&P 500: consume discretionary, consumer staples, energy, financials, health care, industrials, materials, technology and utilities. The 10th asset class is long-term bonds. Each month we will hold the top five best performing  sectors of the market. When less than 5 sectors of the market have a positive return, the portfolio will rotate incrementally into fixed income( provided fixed income has a positive rate of return). Therefore the portfolio can have any of the following allocations: 100% stocks, 80% stocks/20% bonds, 60% stocks/40% bonds, 20% stocks/80% bonds, 100% bonds. This strategy had an annualised return of 13.36% from 1989-2012 compared to 8.55% for the S&P 500. Yes, this is great, but again we do not know how much trading costs, slippage and taxes will eat into our returns.

8. The author says you can also have country based asset rotation and broad global asset class rotation like ( US, EAFE, Emerging, Small, Large, Value and Growth).

9. The author also advocates the use of RSI( relative strength index). When you use RSI, you have to remember that higher the value means the investment class is overbought and therefore has a lower ranking and we should avoid buying it. You can combine this with returns to choose your asset classes.

10. You can also use asset rotation for part of your portfolio and buy and hold for part of your portfolio.

The basic premise of this book is that momentum based asset rotation works. I have also written about in various places on this blog.

Yes, it seems to work but one has to understand that we do not really know the returns after trading costs,slippage and taxes. In a tax-deferred account with minimum slippage and minimum trading costs, it probably works. 

The Pentad Of Happiness

Happiness is simple. We often try to make it complex. Choosing happiness in the present moment, living you life as you want to live it, understanding impermanence and infusing positivity in all things are essential. We can call this the happiness pentad. Let us explore this.

1. Choose happiness: We cannot control the events that happen in our lives. But between each event that happens and our reaction to it, there is a space. We have choice in that space: to see things as opportunities rather than disasters, to think happy thoughts rather than unhappy thoughts and think positive thoughts rather than negative thoughts. The first step is to be aware of that space. To do that we need to establish silence in our beings. Step back before you respond. Do not judge. When you step back, remind yourself thus: Pause, say the words- opportunity, happy, positive, kind,  then respond. As you keep doing this, you will find that you are more happy. This is because you know that you can choose happiness. You can choose because you know there are always options and we can always choose the happy option.

2. Choose happiness now: We cannot live in the past. We cannot live in the future. We can only live in this moment. This moment is what it is- with all its joys, sufferings, happiness, unhappiness, fame, dishonour, money, poverty and all the dualities we can ever think of. The perfection of life lies in the acceptance of its imperfectness. So accept life as it is. So no matter what happens, we have to choose happiness now, because that is the only reality. The now.

3. Choose your life: You have this life in your hands. You can choose what you want to do with it. There is not much point in living according to how others want you to live your life. Why? Because it is your life. Yes, you can take the advice, learn from those who have gone before you. But ultimately, you have to see whether it works for you. We are all at different stages of evolution and nothing is correct or wrong from an absolute sense in most things. So choose how you want to live your life and if you do so, you will find yourself happier and peaceful.

4. Choose to understand that this too will pass: The rose bud blooms into a beautiful flower. It then withers, dries and drops off and goes back into the mud from which it came. Everything will pass away or change. Nothing is permanent. Understand this simple and beautiful truth and that will give you peace that passes all understanding. That will make you happy.

5. Choose to see the sunshine and not the shadow: What this means is to focus on the positive things and bring it gently into everything in your life. The negativity will drop away naturally . Just like the candle dispels darkness. Just like the sun lights the world. There is no point in fighting the darkness. Gently see the light and bring it into your life. The darkness and the negativity will drop off. You will feel happy.

Simple Momentum Strategies Versus Value-Weighted Indexing

Joel Greenblatt wrote a very good book called ” The Big Secret”. In this book he proposes that a value-weighted index is superior to other forms of indexing.

He also gives the returns of a value-weighted indexing strategy from 1990 to the first 6 months of 2010. The CAGR of that strategy was 13.9%.

I was curious to know how my momentum strategy using stocks and gold and my momentum strategy using four highly liquid asset classes performed during this time period.

The CAGRs are as follows( from 1990 to 2010):

  • Value-weighted indexing: 13.9%
  • Momentum strategy using stocks and gold-Top 2: 14.93%
  • Momentum strategy using stocks and gold- Top 3: 13.27%
  • Momentum strategy using four highly liquid asset classes: 12.15%

The CAGRs for Russel 1000 was 7.9% and for S&P 500 was 7.6% during the same time period.

Since Greenblatt has only 6 months of returns for 2010, I wanted to see the returns from 1990-2009 and here they are:

  • Value-weighted indexing: 14.4%
  • Momentum strategy using stocks and gold-Top 2: 14.59%
  • Momentum strategy using stocks and gold- Top 3: 12.77%
  • Momentum strategy using four highly liquid asset classes: 12..07%

You can see the details in this spreadsheet.

It is amazing that simple momentum strategies can almost match Greenblatt and can even outperform his strategy of value indexing. These strategies trounce the US large cap indexes.

You need to remember that the data set is small( only 21 years of data) but it is really interesting.

I think the real issue is whether one can follow this strategy in real-time especially when it underperforms for some or even many years. You need to really believe that this will work in the long-run and have faith in it. That is where most, if not all of us will fail. That is where people like Greenblatt, Buffett, Klarman and Schloss succeed. Because they have the ability to live by this statement of Buffett:

To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.” — Warren Buffett

Value Investing in Growth Companies: Book Notes

This post contains the key ideas from the book, Value Investing In Growth Companies by Rusmin Ang and Victor Chng.

1. Pure value investors focus on the financial numbers and valuation. They do not focus on the business and management. They use quantitative methods to find investments. The main mistake they make is investing in value traps. Value traps are stocks where the stock is perennially low-priced and does not increase in price and therefore no significant profits are made. Pure value investors focus on the past history of the company.

2. Pure growth investors focus on business and management. They do not focus on financial numbers and valuation. They use qualitative methods to find investments. The main mistake they make in investing in growth traps. Growth traps are stocks where future growth is less than expected. Therefore the market decreases their price and therefore no significant profits are made. Pure growth investors focus on the future of the company.

3. A value growth investor focuses on the past, present and future of  a company. They look at the business and management in the past, present and future. They look at the past and present financial numbers. They look at the present and potential future valuation based on the past and present financial numbers and value a company and see whether the company is fairly valued or undervalued or overvalued.

4. The main characteristics of a good growth company are:

  • 15-50% growth over five years.
  • Company should not be mainly financed by debt
  • Company should not be cyclical: their growth should not go down when a recession hits.
  • Not necessary to be in a fast growing industry
  • Have market capitalization below US $ 1 billion, although not all fall under this guideline
  • Possible to purchase at undervalued prices
  • Less covered or studied by institutional investors and analysts
  • Have higher risks than blue-chip companies. The risks could be reduced when you understand the company thoroughly
  • Are more prone to be taken over by bigger companies

5. Short term trading takes a lot of time and is difficult if you have a full-time business or job. As a long term investor you have more time for other activities.

6. The mindsets of successful value-growth investors are:

  • Understand the power of compound interest. Therefore they invest in stocks rather than keep their money in cash.
  • Start at a young age. They save at least 10% of their income to invest.
  • Invest for the long term.
  • Never leverage to invest in the long run.
  • Exercise independent thinking
  • Be emotionally stable: not fall a prey to fear, greed, anger or envy when stock prices go up or down.
  • Think independently and be contrarian if not needed.
  • Do not fall prey to the herd mentality. If we fall prey to the herd mentality, then we fall into self-doubt( doubting whether you are right in not buying the stock). Then we fear losing out on profits. Then we make a bad decisions and buy the stock  because others are also buying.
  • They understand that Mr. Market can be irrational. They are fearful when others are greedy and greedy when others are fearful.
  • They are patient.
  • They assume responsibility for their own actions and for any decision made, be it right or wrong.

7. The four pieces in the jigsaw puzzle to value-growth investing are business, numbers, management and valuation. Financial numbers and valuation are the quantitative aspect while the business and the management itself are quantitative aspects. Both are important.

8. The business:

  • Understand the business model thoroughly, from its raw materials materials to the final products/services used by its customers.
  • Look out for simple and easy-to-understand businesses or businesses within your circle of competence.
  • A good business with strong moats will protect earning power and keep competitors at bay.
  • Identify potential drivers that can continue to generate sales, and, in turn, earnings growth.
  • Assess the business conditions and its growth plan.
  • Read the demographics of a country in which the company intends to expand and the products and services that it will likely benefit from.
  • Understand the risks to a company’s growth

9. The management:

  • Trustworthy: Thinks and acts like the owner of the company.
  • Candid in reporting: Both successes and failures and takes full responsibility for them.
  • Aligned with shareholders’ interests: Receives compensation based on profit sharing. Does not adopt share options. Does not issue additional shares when it is not needed. Holds substantial amount of shares in the company. Buys back shares during crises when they are undervalued.
  • Track record and experience of the management: Seeks to increase revenue and profit through yearly expansion.
  • Visionary managers: Passionate about the business.

10. The numbers: Over 3-5 years, the company should have the following numbers:

  • Revenue growth>15%( any number that doubles in 5 years time is said to be growing at 15% per annum)
  • Cost of goods sold is lower than that of competitors
  • Gross profit margin and net profit margin higher than that of competitors
  • Net profit>15%
  • EPS increases in proportion to net profit
  • Number of outstanding shares does not increase significantly.
  • ROE increasing or more than 15%
  • Debt/equity ratio less than 0.5
  • Dividend payout ratio 15%-50%
  • Cash ratio>0.5
  • CAPEX ratio <80%
  • Positive free cash flow

The above numbers serve as a rule of thumb. Consistency is key when comparing the numbers over the last 5 years.

11. P/E ratio, PEG ratio and DCF valuations can be guides to the value of a company.

12. Margin of safety = Intrinsic value – share price-(cash per share -debt per share)/Intrinsic value x 100%.

13. Screening-Buy-Monitor-Sell

Screening( using numbers against competitors)

  • Stage 1: Increasing trends of revenue, net profit and cash flow.
  • Stage 2: Compare growth rates
  • Stage 3: Consistent margins
  • Stage 4: Debt to equity ratio <0.5 and prefer cash>debt
  • Stage 5: Consistent ROE(>15%), CAPEX(<80%). Otherwise there must be positive free cash flow and a dividend payout ratio of <50%

Buying process( jigsaw puzzle model)

  • Business-pass
  • Management-pass
  • Number-pass
  • Valuation-pass

Monitoring process

  • Monitor once per quarter or year, using the jigsaw puzzle model
  • Sit on cash if you cannot find good stocks

Sell if any of the jigsaw model parts fail.

14. Diversify:

  • Diversification strategy in developed countries: <10 stocks. Diversification strategy in developing countries: 10-20 stocks.
  • Some companies are pretty well diversified internally, be it locally or internationally.
  • Diversify the 10 stocks( developed countries) across different industries.
  • Place a higher percentage of your total invested fund in a growth company in the industry that you understand most.

15. Mistakes in investing:

  • Thinking you are a long-term investor but actually speculating.
  • Trying to time the market in the short run.
  • Investing in high technology and IPO companies
  • Investing in companies that are not consistent
  • Buying a growth trap( not focusing on the quantitative side and overpaying)
  • Buying a value trap( not focusing on the qualitative side and not considering the management and the future profitability of the business operations)
  • Selling your winners and keeping your losers.
  • Underdiversification and overdiversification.

Saturday Stories 29: Immersing Yourself In Sensual Pleasures

Like most people who enjoy sensual pleasures, Asoka’s brother craved power, because power enables you to follow your desires, whatever they may be. He had always hoped that one day he would take over from his brother and become the emperor. But the emperor, who was a devout Buddhist, saw that his brother neither understood nor took an interest in the Dhamma, and he decided to teach him a lesson. One day when he was taking a bath, he left all his regalia outside the bathhouse.

He had arranged for one of his ministers to walk his brother past the robes and regalia. As they went past the bathhouse, the minister said to Asoka’s brother, “Look, the emperor’s robes—he must be bathing. you’re going to be the emperor one day—why don’t you try them on?” Asoka’s brother replied, “I can’t; it’s against the law and would be a capital offense.”

The minister urged him on: “No, no, it’s alright, you can try them on; no one will know.” So he did, and because it was a setup, Asoka came straight out of the bathhouse and said, “What are you doing? That’s a capital offense! Even though you are my brother, I have to apply the law fairly. I’m sorry, brother, but you will have to be executed.”

Asoka then continued, “But since you want to be the emperor so much, and because you are my brother, you can be the emperor for seven days.
you can enjoy all the pleasures of the harem, all the food from my kitchens, all the musicians in my court, and anything else you desire. But
you can’t commute your own sentence, and in seven days I’ll execute you.”

At the end of those seven days, he had his brother brought to him with the executioner waiting.

Asoka asked his brother, “Did you enjoy yourself during those seven days?”

His brother replied, “How could I enjoy myself when I knew I was going to die in a few days? I couldn’t even sleep, let alone enjoy myself.”

Before setting his brother free, Emperor Asoka drove the lesson home: “Whether it’s seven days, seven months, seven years, or twenty-seven years, how can you thoughtlessly immerse yourself in sensual pleasures when you know that death is waiting for you?”