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.
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