F Wall Street: Book Notes

This post has my personal notes about the big ideas in the book F Wall Street: Joe Ponzio’s non-nonsense approach to value investing for the rest of us by Joe Ponzio.

1. Joe Ponzio’s asks us to change our perspective. He says that saving and investing in mutual funds alone will not guarantee a comfortable retirement. My view on this is it is true if you follow what Wall Street says. There is a different way, though. You can read this in my post on how to secure your financial future. This method should give you very good results over multidecades. This can be followed by anyone, and you need not know how to pick stocks and sell and buy at the right time. This is good for the buy and hold and know nothing investor which most of us are and has the recommendation of no less than Warren Buffet.

2. He then talks about some myths.
The first myth: It’s a great investment. This is true if you are talking of individual stocks. But a balance portfolio of low-cost index funds including equity and bonds is really a perfect investment for most people.
The second myth: You should diversify. If you are Warren Buffet, you do not need to diversify. But otherwise diversification is really a good idea.
The third myth: You need to be in the stock market. History says that the stock market has given the best post inflation returns over multidecades( 30-40 years). Hence being in the stock market is necessary.
The fourth myth: You need to take high risks to earn high returns. This is true if you are investing in individual stocks and want to find the next Microsoft. But with a balance portfolio of index funds, you do get good enough returns with reasonable risk.
The fifth myth: Start early. Today’s good. Compounding is the most amazing power in the whole universe. To allow it to show its power, you need to start early.
The sixth myth: Investing requires a lot of brainpower, time and work. This is true. If you adopt a balanced portfolio of low-cost index funds, you do not need to spend a lot of brain, time or work.
The seventh myth: You cannot beat the market. Well, this is true, in a sense. If you follow the balanced portfolio of low-cost index funds, you probably will beat the market in the long run, or at least 98% of the market.
You can control your spending, you can decide how much to save. You can decide how you will invest. But the exact returns you will get, nobody in the world can predict. Focus on process, not outcomes.

3. Stocks are not necessarily always risky; bonds are not necessarily always safe. Risk is not inherent in an investment opportunity; it is only inherent in the price you pay. This is true. But to actually predict the value is difficult. Therefore it is better to own both and be happy.

4. This is an important point Joe makes: Cash is more important than earnings. It is entirely possible for a company to generate profits while operating at a cash loss. When that happens, take heed. Growth, success and stability in business all come down to one simple thing: cash. Not net income or profits or EPS. When companies generate cash, they can pay off debt, take on more good debt, enter new markets, make acquisitions, buy back shares and pay dividends. All these will make the shareholder more rich. When companies cannot generate cash, they have to assume more debt, sell assets and sell more stock. This makes the shareholders poorer.

5. What is net worth? Total assets minus total liabilities. When you buy a share, you are buying a share of the net worth of the business and its future cashflow. If the net worth and the cashflow goes up, the value of the company goes up and vice versa. An asset is anything that produces positive cash, allowing for taxes and inflation. A liability is anything that produces negative cash. Even debt can be an asset and an asset can be a liability depending on the cash it generates. There are two types of companies: companies that have a high cost of business- meaning, they need to keep investing in assets and equipment, if they want to grow. Then there are low-cost businesses, which require very little money to run. If this type of business generates a lot of cash, then they can use that cash to grow. We should want to invest in these kinds of businesses.

6. Invest like it’s 1966. This means invest as if the information you have is similar to what you had in 1966. This means:

1. Do not worry about the daily quotes.
2. Buy stocks when they are on sale, when they have gone down.
3. Understand how to value a business and the difference between the price quoted and the value.
4. Understand that the stock market quote has no bearing on the value of the business.
5. Understand that over time price will follow value.
6. Do not buy and sell often.
7. Use the internet for your advantage but do not fooled by all the trivia.
8. The people who try to beat the markets on a short-term basis and chasing performance will lose in the long run. So be patient and win.
9. If you buy well, you do not need to spend a lot of time monitoring your stocks.
10. Whenever you are buying a large stock or a small stock, you are buying a business. Remember that.

7. How to value a business: The best method to value a business is to calculate owner earnings.

Owner earnings=Net income+depreciation and amortization+non-cash charges- average capital expenditures

  • Net income=9086
  • Depreciation+amortisation=1982
  • Average capital expenditures= 2686+2780+2920+2215+1993/5=2518.8
  • Non cash charges=-234
  • Owner earnings=9086+1982-234-2518.8=8315.2

For extremely large, stable business, free cash flow approximates owner earnings
Free cash flow =Net cash provided by operations- average capital expenditures
Free cash flow for Coca Cola for the year 2012-12 is: 10645-2780=7865

See how these two numbers are almost equal.

8. Forget price-focus on intrinsic value. Intrinsic value depends on the return you want to get. If you have a bond worth 1000 paying 5% interest, the intrinsic value is 1000 if you can accept a return of 5%.  If your goal is to earn 20% on your investment in a year, the intrinsic value of the bond has to be lower. Infact it is 875.

In a business, the value lies in the future. You need to understand the business and you need to be certain you will get the return you want. But that is not possible 100% of the time, even for Buffett.

The quickest way to value a business is the cash yield method

Cash yield= owner earnings or free cash flow/ market cap x 100
For Coca- Cola, the cash yield at the end of 2012 was: 8315/188100=4.4%
The five year US treasury yield is 0.90%
Based on this Coca Cola is undervalued.

The more detailed method to value a company is the buy and hold method. This takes into account, the value of the networth and the value of future cash.

To do this we have to:

  • Project the future cash flow of a business
  • Figure out what we can pay for that future cash flow by discounting it based on the return we hope to achieve
  • Add in the value of the business’s net worth to get the intrinsic value
  • Determine our margin of safety and target purchase price.

Let’s do this for Coca-Cola again at the end of 2012-12:

Share holders equity: 32790

Lets say the cash flow increases at a rate of 8% for the first 10 years and then levels off to 6% subsequently.

Use this calculator to calculate the value of future cash flows: The value of Coca Cola’s future cash flow is 194634.92

  • The total value= 32790+194634.92=227424.92
  • Value per share= 227424.92/4602=49.41
  • As of today Coca Cola is selling at 42.74.
  • Therefore it is a bit undervalued.

But you have to be able to predict the cash flows a long time out. That is why it is so difficult to value a company. But if you can predict the cash flows well and it is priced a lot less than the market price, you can make a bundle.

9. No brainer investment opportunities: There are few criteria for an investment to be a no-brainer:

  • It has to be within the sphere of your confidence and competence
  • It has to be a strong business, needs to have a moat and needs to be able to grow and make money 5-20 years from now.
  • The cash return on invested capital has to be greater than 10%. This is equal to owner earnings or free cash flow divided by ( Share holder’s equity+long term liabilities)
  • Then you need a margin of safety.

10. The ten commandments of investing:

  1. Never invest in anything you do not understand.
  2. Price follows value over the long term
  3. Price volatility does not imply any additional or reduced risk; the risk is in the price you pay and your evaluation of the opportunity.
  4. The stock market is a place to buy and sell businesses regardless of the myriad of other(or faster) ways to make or lose money in stocks.
  5. There is no tomorrow, only “five years from now.”
  6. Earnings are for the IRS and accountants; business owners and silent partners rely on cash.
  7. A great business is one that will survive the bad times; so wait for the bad times to invest in great businesses.
  8. Unless it affects the business of your company or it’s filed with the SEC, it’s just noise. Analyst opinions and general market trends do not affect the business of your company and are not filed with the SEC.
  9. He who turns over the most rocks, wins.
  10. If you don’t have a margin of safety, you don’t have a good opportunity.

11. What should you use as your discount rate? You should use the greater of 9% or the interest rate on the ten-year treasury.

12. Time to buy, but how much?

  • Industry leaders( market cap > $10 billion): 25% margin of safety: 10-25% of portfolio, maximum 40% of portfolio in any one opportunity
  • Middler( market cap: $1 billion-$10 billion): 50% margin of safety: maximum 10% of portfolio in any one opportunity
  • Small fish( market cap: less than $ 1 billion): atleast 50% margin of safety: maximum 5% of portfolio in any one opportunity
  • The above percentages may not apply for small portfolios.
  • The percentage of your portfolio that you invest in a company refer to the time of purchase.
  • Be strict with the margin of safety.

13. Tracking the value of your business: You should follow your investments carefully, atleast every quarter, to look for problems and predictability

14. When to sell:

  • Price rises to meet value.
  • Value drops to meet price.
  • Take a loss if needed.

13. Workouts are complex. Read the book for the details.

14. The different types of investors:

  • The general conventionalist: 100% in bonds, CDs and cash.
  • The enterprising conventionalist: 50% fixed income, 50% in dividend paying stocks of large companies or established , proven equity funds.
  • The safety seeker: One part as an enterprising conventionalist, one part as a unconventionalist
  • The non-conventionalists: They are opportunistic investors who are very conservative and have a very good sense of price and value.

15. Remember the definition of investing: an investment operation, which upon thorough analysis promises safety of principal and a satisfactory return.

16. The basics of buying bonds: Rather than Buying certificates of deposit from the bank, you can become a banker yourself by buying bonds. You can buy treasury bonds, or corporate bonds. The yield to maturity, the face value and the price you pay all affect your returns. Bond laddering is a useful way to buy bonds. Bond funds are another way to buy bonds but they have three bad properties: fees, other investors and maturities( no maturity) because they keep investing.

17. To be successful in investing, you need a lot of patience: patience in portfolio growth, patience in finding investments, patience with the gamblers, patience with your family and friends, patience with your returns, patience with your portfolio value, patience with your spending and patience with Wall Street.