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Follow the rules! - Views on News from Equitymaster
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  • Oct 12, 2007

    Follow the rules!

    The Indian stock market made historic moves this week, breaking the old records and making some new ones. The BSE-Sensex hit the 18,000 mark. Not only the blue chips but also the small caps have been scaling higher. However, one should not get carried away by the hype. Investment Guru, Warren Buffet has suggested some rules before making an investment. These rules fall into 4 groups, which are as follows:

    Business Rules: This includes the basic characteristics of the business itself. The business tenets focus on understanding how the business operates.

    The first rule to be followed before buying a stock is never to invest in a business you cannot understand. This means that time needs to be spent on understanding the business. One can make short-term gains through stock tips, but in the long run, this will not help. "Poker players are not gamblers". The good players win on their skill, temperament, and intimate knowledge of the game and do not rely on luck to win the game.

    The firm should also have a stable operating history. One should know whether the company has stood the test of time. The company, which has experienced different economic cycles and competition and has survived, is a safe bet. A company can have lower profit periods and still have a consistent operating history. These low profit periods can provide a good opportunity to purchase a good business at a low price. Further, knowing the long-term prospects of the business is also necessary. Technological aspects, competition, government rules, bargaining power, raw material supplies should be considered before making an investment.

    Hence, in order to achieve this high level of competency, it is necessary to limit the scope of investigation and investment to a small number of companies. This necessitates a focused portfolio instead of a diversified one.

    Management Rules: This refers to the quality of management. It is essential to have a strong management as the fate of the ship i.e. whether it would float or sink would depend on their competence. The management of the company should be high on corporate governance and ethics. The decisions taken by the management should be in the best interest of the shareholders. Inspite of the happenings in the economy or the market, a company with a strong management that knows how to make money, can make money, and will keep making money.

    Financial Rules: This refers to the various financial parameters that should be considered for evaluating a stock.

    Profit margins: According to Warren Buffet, the companies, which are able to earn higher margins along with high volumes, are a better bet. Falling volumes may indicate higher competition or the fact that the company has responded late to market changes. Further care should also be taken on the leverage factor. Higher interest costs reduce the margins.

    ROE: Mr. Buffet considers return on equity (ROE) as a better measure of annual performance as it takes into consideration the company's capital base. By looking at ROE, one is able to determine how efficient the company is at using both shareholder's capital and debt to produce income. He uses the modified version of what he called owner earnings. This is the cash flow available to shareholders, or the free cash flow to equity. It is defined as net income plus depreciation and amortization (i.e. adding back non-cash charges) minus capital expenditures minus additional working capital needs. This indicates the company's ability to generate cash for shareholders.

    One-dollar premise is also an important measure. Buffet's goal is to select companies in which each rupee of retained earning is translated into at least one rupee of market value. If retained earnings are invested in the company and produce above average return, there would be a rise in the company's market value. It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Buying a stock on basis of the price that is well below its book value; but without considering its margin, return-on-equity, owner earnings and profitability history may prove to be a bad choice.

    Market rules: This is from the market perspective.

    Value of a business: Buffet's rule is to purchase the business only when its price is at a significant discount to its value. The value of the business is determined by the estimated cash flows expected to occur over the life of the business discounted at an appropriate interest rate. Use of conservative estimates of earnings and the riskless rate, as the discount rate is always a safe bet. Though calculating the value of the business is not difficult, estimating the cash flows may create problems. Hence selecting businesses, which are simple to understand and stable would help. Further, having margin of safety would minimize risks.

    One should stop trying to predict the direction of the stock market. Mr. Market is unpredictable and moody. If shares of good businesses are owned, market action on a day-to-day basis becomes inconsequential. What matters is the big picture trend of the company's operations, management and culture.



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