The Conscious Investor - Profiting from the Timeless Value Approach

The stock market is an extraordinary outcome of human ingenuity. Buying shares on the stock market gives you ownership of parts of some of the world’s greatest companies. For under a hundred dollars you can buy a piece of Microsoft or Intel, companies that have revolutionized the way we do business and, indeed, most parts of our lives. You can buy a piece of Wal-Mart or Costco, companies that have changed the way millions of people shop. Or, in a different direction, you can buy shares in new sustainable energy companies such as Suntech in solar energy or Vestas Wind Systems in wind energy, companies that are shifting how we see our relationship with our environment.

As a shareholder you have ownership rights such as voting for directors, receiving dividends, and sharing in the proceeds of a corporate liquidation. But as an investor the key goal is to choose stocks that will be profitable. This is the focus of this book: showing how to be a successful investor by determining the real value of stocks. This will be done through a careful analysis of quantitative methods of equity evaluation to determine whether an investment will make money or not. Putting it simply, we are going to examine what separates wealth winners from mere speculative hopefuls.

Successful investing depends on knowing what to buy and when to do it. Then it depends on knowing when to hold and when to sell. The problem is how to do this. We often talk about the stock market in terms of a human psyche with a mind of its own: euphoric highs, depressing lows, tedious doldrums. And it is hard not to think of it this way. For example, from 1975 to 1985, on average the U.S. stock market reflected around 50 percent of the value of the underlying assets, according to U.S. Treasury tables. This means that a very large investor, by buying all the stock of companies traded on U.S. markets, could get the lot for about half the price of what the overall market was worth. Such an investor would be getting everything for 50 cents on the dollar. Then the market started climbing until in 2000 it was close to twice the value of the underlying assets. Next it crashed to undervalued levels in 2008 but has now crept up until it is slightly overvalued once again in early 2010.

Another example of the bipolar nature of the stock market is the price of Berkshire Hathaway, the company run by legendary investor Warren Buffett. Since he has been in charge of the company there have been four occasions when the price has dropped by around 50 percent. The first three times were in 1974, in 1987, and in 1998. Each time, like a punch-drunk fighter, it picked itself up off the canvas and headed for record highs. Consider the fact that Buffett bought his first shares in the business for $7.50 on Wednesday, December 12, 1962, and on Tuesday, December 11, 2007, almost exactly 45 years later, they reached $151,650, an all-time high. This is an average return of 24.65 percent per year. After that the price tumbled to a low of $70,050 on Thursday, March 5, 2009. Within six months it was back over $100,000, and by March 2010 it was over $125,000, so the chances are that the price will move to record highs once again. These massive price swings have little if anything to do with the underlying business. Every year the company, under the astute leadership of Buffett, continues to invest its capital in a wide range of quality businesses either via the stock market or through direct purchase of private companies. Except on two occasions, every year the equity of the business on a per-share basis has gone up, a remarkable record. However, if you only looked at the share price, you would conclude that the business was continually alternating between periods of wild success and dismal failure.

It is our job to look behind these manic-depressive swings of the overall market and individual companies where prices seem to oscillate between astronomical highs and pitiless lows. For example, what is it that drives the share price of Berkshire Hathaway upward over the years despite the short-term volatility? In a nutshell, it is the strength of the underlying business. For a start, when a company announces strong improvements in its sales and earnings, generally its price goes up. If it announces the opposite, generally its price goes down. More importantly, over a longer time frame, the prices of successful businesses tend to rise and the prices of poorly performing businesses tend to fall, the speed and sizes of these rises and falls depending on the degree of success or otherwise of the business. Many years ago, Benjamin Graham, often referred to as the dean of Wall Street, said it clearly: “In the short term the market is a voting machine, in the long term it is a weighing machine.”

What is it weighing? Value. And value and the valuation of equities are what this book is about. It is all about how to weigh or measure the value of stocks. If we can’t measure value, then we cannot tell if any stock that we purchase is likely to be profitable. We are left to be kicked around by the market’s whims and uncertainties. This is particularly true at the present time since, according to George Soros, we are experiencing the “the worst financial crisis since the 1930s.” Yet history shows that it was during times of past turbulence and uncertainty that many astute investors made their greatest profits.

After making a purchase of shares in a company, it takes time to be sure that it was profitable and, hence, that it represented value. If the price goes up over our time frame we can look back and say that when we made the purchase the price we paid was good value. If the price goes down, we say the opposite. The problem facing every investor is to be able to determine at the time of the purchase whether the investment is likely to be profitable or not, and not wait until the price has actually gone up or down. This is done by measuring the real value of the equity when the purchase is being considered.

Like most important areas in life, this measurement of value is both a science and an art. It is both objective and subjective. As a science, measurement of value involves careful calculations using specific financial inputs based on approved and audited financial statements. The outcome is usually referred to as intrinsic value, which is taken as the true worth of the equity independent of investor and market opinions. The measurement of real value comes by comparing this intrinsic value with the actual price. If the intrinsic value is high compared to the price, then we are encouraged to go ahead with the purchase. Otherwise we would be wise to leave it alone.

At the same time, measurement of value is an art because there are actually dozens of ways of measuring intrinsic value, each with its own set of inputs. Often the outcomes for the same stock are hugely different so that which method to use and the levels of the inputs are judgments to be made. In this book each valuation method is followed by a clear list of its strengths and weaknesses so that you can make an informed choice if you wish to use that method. Just as importantly, you can be aware of what to watch out for when reading a report on a company that discusses its value using a particular valuation method.

The fundamental assumption of value is that over time, the price of a stock will move toward its true worth or intrinsic value. Just like a swarm of mosquitoes appear to be flying randomly, but overall unerringly move toward an uncovered arm, so the millions of investors drive the stock price, by a series of persistent up and down nudges, toward its value. The difference is that for mosquitoes the time frame is minutes, while for the stock market it can be months and even years.

In fact, this tendency of prices leads to a second assumption, namely that stocks that are more undervalued will initially rise in price more quickly than those that are less undervalued. In other words, they will have a higher rate of return. This means that we have two core questions when making investment decisions: How much is it really worth? And, if it is undervalued, is the market price substantially below the true worth? These questions, particularly the first one, are the focus of the methods covered in Chapters 6 to 10 and then again in Chapter 12.

The preceding discussion leads, however, to an even more fundamental question for investors, namely: What rate of return can I confidently expect to get? In the end, this is the all-important question for making investment decisions. Even if a stock is undervalued by 50 percent, it is no use as an investment if we do not have confidence at the outset about the growth of its price. For example, the fact that it is highly undervalued does not tell us when, or indeed if, the price will move upward in our time frame. The stock may continue to stay undervalued by 50 percent for years. As investors we want to know at the time of our purchase whether we are going to make money or not, and how much we are likely to make. In other words, what is our anticipated rate of return? This means that we don’t even need to calculate intrinsic value provided we can calculate the expected rate of return. Methods are presented in Chapters 11 and 13 that go straight to such calculations.

The major stock markets around the world are maelstroms of activity. Every day, untold numbers of transactions are made by hundreds of thousands of people involving thousands of companies. With an online brokerage account and a basic home computer, it can be done with a few key strokes and mouse clicks. On one hand, are the parents at home with children on their knees, the office workers in their work cubicles, and the...