The Midas Touch: Book Notes

This post contains my personal notes from the book, The Midas Touch by John Train.

Some investment guideposts according to Warren Buffett’s investing style

  • Don’t be guided by what other people say.
  • If you accept clients don’t tell them what you are doing when you are doing it. Decline to tell your investors what they have their money in.
  • Keep your perspective by looking at what is important and not what is urgent or fashionable. Always separate the wheat from the chaff.
  • Be in a place where you can think about the markets and life. Don’t hear so many stories. Just sit and think about the stock in front of you.
  • Never attempt another “turnaround” in an operating company. Running a company is completely a different art from buying and selling stocks.
  • Choose your investments on the basis of value and not popularity.
  • Operate in the markets in such a way that you attempt to reduce permanent capital loss( not short-term quotational loss) to a minimum.
  • The essence of business investment is this: Buy a stock at the largest possible discount from true value, and not chasing it up because it is supposed to be headed even higher.
  • When the market is behaving irrationally and you do not find any ideas, say as Buffet said: I am out of step with present conditions. When the game is no longer played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, and so on. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand ( although I find it difficult to apply ) even though it may mean foregoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully, and which possibly could lead to substantial permanent loss of capital.
  • When the market collapses, take advantage of the extraordinary bargains that become available. Say as Buffet said: I am a sex-starved guy in a harem.

Benjamin Graham’s simple investment methods

Benjamin Graham has written detailed methods of security analysis in the Bible that goes by the same name. However he has written about simpler methods as well:

  1. Buy a stock for a price that is less than 2/3rds of the company’s net quick assets, deducting all prior charges and give no weight to the other assets. Always hold a lot of these stocks for diversifications and buy odd lots if needed. Sell once you make a 50% profit.
  2. Buy a stock whose yield is greater than twice the yield on AAA corporate bonds. The total debt of such a company should also not exceed its tangible net worth.
  3. Buy a stock whose dividend yield is greater than 2/3rds of the AAA corporate bond yield.The total debt of such a company should also not exceed its tangible net worth.

When you use the above three criteria to buy stocks, you have to buy all stocks that fulfill these criteria and not choose.

The selling criteria were as follows:

  • Sell at 50% profit or sell at two years, whichever is earlier.
  • Sell if the dividend is omitted.
  • Sell if the price falls by another 50%

Graham’s Value and Safety Criteria Screen

A stock can be bought if it satisfies one value criteria and one safety criteria.

Value criteria

  1. An earnings-to-price yield at least twice the AAA bond rate
  2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
  3. Dividend yield of at least 2/3 the AAA bond yield
  4. Stock price below 2/3 of tangible book value per share
  5. Stock price below 2/3 of Net Current Asset Value (NCAV)

Safety criteria

  • Total debt less than book value
  • Current ratio great than 2
  • Total debt less than 2 times Net Current Asset Value (NCAV)
  • Earnings growth of prior 10 years at least at a 7% annual compound rate
  • Stability of growth of earnings in that no more than 2 declines of 5% or more in year end earnings in the prior 10 years are permissible.

He particularly favoured the first within each section.

Investment principles of Philip Fisher

Fisher’s strengths are remorseless thoroughness and concentration on a few things. He does not like banks or insurance companies and is also wary of consumer companies. He is a growth investor but does not invest in the new hot things. He wants to invest in the leader  in a settled down fully competitive area. They will have high margins, turn over inventory more rapidly, have the best research effort, management with integrity, effective cost-cutting, employee friendly, dedicated to long-term growth and invest in research and new products.You should never sell off a winner to buy a lot of losers. Because it is hard to identify winners and then actually have them succeed. There is no advantage trading these for a lot of uncertainty.

So, the key takeaways from Fisher, that Buffett also agrees with are:

  • Only buy a company that is first-class in its way.
  • Insist on management of utmost competence.
  • Do not touch a company that is dishonest or tries to profit unreasonably at the expense of its shareholders. It should also be straightforward and truthful in its reports to its shareholders
  • Buy a company that you are willing to hold for a long time.

The other things that Buffett does is invest in franchises that have a moat and not a commodity type business. It is great if you can find an unregulated  monopoly.

Good and bad businesses

Buy good businesses as shown by:

  1. High return on invested capital
  2. Creates its profit in cash, not just accounting profits.
  3. Rapid turnover of inventory, high rate of return on the total of plant plus inventory, and have predictable earnings
  4. The manager thinks like an owner
  5. Enjoy a strong business franchise, so that it can pass costs to the customer
  6. Toll bridge or gross profits royalty on the sales of other businesses. Monopoly or oligopoly.
  7. Definable character that does not keep changing
  8. Should not have complex management problems

Do not buy bad businesses as shown by:

  1. Makes money in accounting profits rather than cash
  2. Needs more and more investment as sales grow
  3. Has dishonest or grasping managers
  4. The business profoundly changes character from time to time
  5. Business that provides a service or commodity for a long time in the future and is not able to protect itself against inflation.
  6. Farming related businesses
  7. Retailing companies
  8. Life insurance
  9. Large capital intensive companies- steel, automobile, utility, most heavy chemical, oil and appliance companies and mining companies
  10. Businesses subject to stringent government regulation

Miscellaneous thoughts

Value will in time be reflected in market price. It may happen immediately but more often it will take around  3 years, sometimes 3-5 years. Some ways of improving this is to talk about your undervalued stock or buy once the relative strength of the stock against the market starts to go up.

The other thing is to buy stocks when there is a disaster to the company or on a war scare. Also be aware when a good business is overpriced. People like Buffett know what the whole company is worth and can assess the worth quickly. And if the whole company is selling at a price less than what it is worth, it is worthwhile buying stock in that company. An if you keep betting when you have favourable odds, then you are investing with less risk. And the time to buy is when the price goes down and not up. And if you invest in such a way, then you will know that markets are not efficient. To do this you have to buy well and then just sit tight and not do anything for long periods of time.

Buffet uses leverage in interesting ways. He uses the float that his insurance company gets to invest in cheap stocks and get high returns using other people’s money. He also buys businesses with a lot of free cash. He uses the free cash to buy other cheap companies and makes a lot of money. Today, people who buy such companies with borrowed cash engage in what is called leveraged buy-outs.

A impregnable business franchise or good will is worth more than the actual fixed assets, especially in times of inflation. This is because such a business can charge more and continue to be profitable.

Buffet keeps things simple. He does not indulge in complicated things. But he reads a lot and consults Charlie Munger. And looks for value all the time. If he sees it, he buys a good amount of it. He also believes that if a company does not have a high return on capital, it should either pay a lot of dividends or repurchase its own stock if it was cheap. He likes special distributions for its tax benefits. He hates stock options

Regarding how to invest we can give some pointers. Know accounting. Try to estimate the value. Buy companies bought by notable value investors and coat tail them. Avoid risky things. And keep being steady to get the power of compounding work for you.

Equities as bonds

Equities can be considered as bonds. There are two things you need to consider. One is the return on book value. This can be calculated very simply by earnings per share divided by book value per share. The next is the book value itself. You have to compare it what yield a particular bond will give you.

For example: If the return on book value is 12% and you can buy the stock at book value, you have a return of 12%. If the bond yield is say 6% then you have a very good investment. If  you have to buy the stock at twice the book value, you only have a return of 6%. Then if the bond gives you 6%, the bond is a better investment as with stocks you have risk while with bonds you do not have risk. And with stocks you can reinvest it perpetually at 12% if the price remains close to book value. Stocks do better than bonds during inflation. Hence Buffett never buys a long-term bond only short-term bonds.

Things that it takes to be a good investor

  1. You have to want to do it enough to overcome the difficulties.
  2. You have to be original.
  3. You have to be sure of what you are doing.
  4. Be flexible about buying stocks in different industries.
  5. Only buy a stock the way you would buy a house you intended to live in.
  6. Be thorough, cautious and risk-averse. Remember Buffett’s rules. Never lose money. Never forget that you must never lose money.
  7. All this requires energy and determination.

Things that make a bad investor

  1. You do not have the knowledge or qualifications or do your homework. you titillate from one story to the next like a butterfly.
  2. You buy at tops and fall victim to fashion investing.
  3. You do not know what a business is worth.
  4. You have a high turnover in your portfolio.
  5. You think of stock investing as betting rather than thinking of it as buying a business.