“What stock should I buy?”
Even before we ask that question, we must know the different type of stocks.
And how you should treat them from start to finish – that is the value investing theme.
1. Cigar Butts
Benjamin Graham espoused the philosophy of buying average companies and dirt-cheap prices. But Walter Schloss made an entire career out of it.
|To do||Screening + Concalls|
|Catalyst||Capital cycle upturn|
|Buy||0.4x book value|
|Sell||1.2x book value|
|Masters||Ben Graham. Walter Schloss. Li Lu (early)|
- Use book value. They are more stable than earnings.
- If you buy earnings, you have to know a lot about the company.
- Beware of debt.
- Look for mult-year lows, not just 52-week lows.
- Before selling, reevaluate the company. Compare with book value again.
- Scale up and scale down.
|To do||Screening + Annual reports|
|Catalyst||Temporary crisis. Great underlying business.|
|Buy||High ROC + Reinvestment|
|Masters||Charlie Munger, Phil Fisher, Terry Smith|
Warren Buffett talks about 3 types of businesses:
- Great Business: Capital light. Has excellent return on capital (ROC) because of a moat due to a low cost of production, or famous brands.
The moat is durable because, its industry is stable and it’s not dependent on superstar managers.
Example: See’s Candy, Microsoft, Google, Nestle India, HUL.
- Good Business: Capital heavy. Decent ROC. Also has moats. Example: Utilities like Indraprastha Gas.
- Gruesome Business: Very capital heavy. Poor ROC. Moats don’t endure. Example: Jet Airways.
- There are 3 types of businesses – the great, the good and the gruesome:3Berkshire shareholder letter, 2007, P6
|Return on capital||High||Moderate||Poor|
- In the case of great businesses, organic growth is optional. In fact, it is unlikely. Because lightning doesn’t strike twice. Very high ROC is hard to repeat again.
Hence, the investor has to create her own inorganic growth. In her portfolio.
- Stable industries tend to have low growth rates.
Also, the number of players tends to shrink over time. And profit pool tends to consolidate in the hands of the strongest player.
- A good way to judge capital intensity is to compare depreciation with capital expenditure. In this type of business, capex > depreciation.
- Oddly, such a business may have a high growth rate! 🙂
3. Growth Story
|Catalyst||Earnings. Traction seen during scuttlebutt.|
|Sell||Story is over|
- Slow Growers: These are old companies, whose days of growth are now behind them.
- Fast growers:
- Asset plays:
4. Special Situations
|To do||Search for Demerger, Merger securities, Slump sale|
|Buy||Understandable + Bargain|
|Sell||Average co: Sell. Great co: Hold.|
|Master||Joel Greenblatt (early)|
5. Magic Formula
|Track||Earnings yield (EY)|
|To do||Screen + Annual reports + Concalls|
|Master||Joel Greenblatt (later)|
Note: Warren Buffett
The Oracle of Omaha has used many of these themes, over his career.
Secret 1: Small Sums of Money
- Old school cigar butts are difficult to find now. You’ll only find them when the stock market is cheap. And precisely then, wonderful companies will also be cheap. Go for the latter.5Berkshire AGM, 2001, Afternoon session, Q33, 2:26:57
Either: Cigar butt or Wonderful
- “Either is fine. Cigar butts, better for small sums. Wonderful companies, better for large sums.”6Personal correspondence with Shai Dardashti, 2007, P5
Both: Cigar butt + Wonderful
- I’d look among classic Graham stocks – very low PEs and maybe below working capital. I’d comb that sort of a list. There are thousands of potential opportunities. I’d do far better percentage wise, than I do now.
If I found a wonderful company and I was really convinced about its future, I’d buy that also.
Incidentally, I bought GEICO in 1951, when I had $10,000. It was exactly the sort of stock that Graham wouldn’t buy. It was selling way above book value. But I’m glad I did it.7Launch of Berkshire insurance in India, 2011, YouTube video, 9:52
|↑1||Factors needed to make money in the stock market by Walter Schloss, 1994|
|↑2||Also see: Warren Buffett – Value Investing Themes|
|↑3||Berkshire shareholder letter, 2007, P6|
|↑4||One Up On Wall Street by Peter Lynch|
|↑5||Berkshire AGM, 2001, Afternoon session, Q33, 2:26:57|
|↑6||Personal correspondence with Shai Dardashti, 2007, P5|
|↑7||Launch of Berkshire insurance in India, 2011, YouTube video, 9:52|