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DIY Shares - Value Investing Education articles

The five step plan to successful value investing in shares

By Roger Montgomery

 

If you have ever paid a high price for a share, it is time to turn your back on speculating and start investing. Stop hoping for a spectacular short-term return and start being certain of a great long-term one.

 

Unlike speculators, investors see shares for what they really represent: fractional pieces of an operating business. Shares of good businesses outperform the broader market over time and if you buy pieces of a good business, the shares will generally take care of themselves. Buy those shares at bargain, or even reasonable, prices and the returns can be spectacular.

 

Last year in Money Magazine I suggested 11 businesses that I thought Warren Buffett would be interested in. These days I refer to these types of businesses as my A1 businesses. They were ANZ Bank, Commonwealth Bank, Cochlear, CSL, Fleetwood Corp, National Bank, REA Group, The Reject Shop, Westpac and Woolworths. As at 22 March 2010, those businesses achieved a pre-tax return of 43.48 per cent, compared to the All Ordinaries Accumulation Index of 26.60 per cent.

 

Value-investing works and, perhaps most importantly, almost anyone is capable of following it because apart from some relatively simple tools, which I can give you, discipline is the only other ingredient you need.

 

The five-step plan that makes sense

There are five keys to making value-investing work for you. Although the detailed recipe to reproducing my returns have been laid out in the first edition of my guidebook to valuing the best shares there is enough room here for the basic ingredients to get you started.

 

Step 1: Buy businesses, do not punt on shares. Treat shares as part-ownership stakes of a business rather than bits of paper that wiggle up and down on a computer screen.

 

Step 2: Own businesses that will grow. Buy businesses that can grow organically and substantially.

 

Step 3: Be sure a competitive advantage exists. Refrain from buying businesses without a valuable competitive advantage.

 

Step 4: Stick to businesses with high rates of return on equity (ROE). Buy businesses with a demonstrated track record of generating high return on equity with little or no debt.

 

Step 5: The intrinsic value formula and safety margin. Buy these businesses for less than they are really worth.

 

Step one: Buy businesses, do not punt on shares

Far too many investors take their signals for what to do in the sharemarket from the price of a company's shares. Confusing the performance of a business with the performance of its shares is a fundamental mistake that is lost on those destined to see their returns merely rise and fall with the market.

 

Have you bought shares that went up for a while and then tanked? It is not the only possibility but it is highly likely the rising share price that lured you in was not supported by the underlying performance of the business. Think about Babcock and Brown, Allco and ABC Learning Centres. In the short run the market for these shares was a popularity contest. In the long run, share prices reflect the performance and true value of a business.

 

If you focus on businesses rather than shares, you will not be lulled by the mesmerising influence of daily price gyrations. Focus on the business and the shares will look after themselves.Investing involves buying a piece of a business. Buying a share and hoping its price will go up is speculating.

 

Step two: Own businesses that will grow

First prize is a business whose profits will be materially higher in five, 10 or 15 years from now. Put together a portfolio of businesses whose earnings march upwards year after year and eventually so will the portfolio.

 

If you have a mortgage and children to put through school and you cannot wait five, 10 or 15 years, you should not be in the sharemarket - yet. You can get a guaranteed return of around 12 per cent, pre-tax, just by paying off the mortgage. Divide the interest rate on your mortgage by one-minus-your-tax-rate and that is your guaranteed pre-tax return from paying off the mortgage first. Only invest in the sharemarket if you are certain of a return much higher than that rate, or you have paid off the mortgage.

 

Companies that can be much larger in the future, particularly those that generate lots of free cash to self-fund their expansion, pay dividends or repurchase shares, are the best businesses to own. Ask yourself: can this business be a lot bigger than it is now?

 

Step three: Be sure a competitive advantage exists

A competitive advantage is the only way high rates of return on equity can be sustained by a company and the most valuable competitive advantage can be summarised in a few words: the ability to raise prices.

 

If a company can regularly increase the price of its products or services without a detrimental effect on unit sales volume, and it has demonstrated this over time, then it has something truly valuable. To maintain the advantage, there must be a barrier to imitation by competitors.

 

There are many paths to this goal for a company. Sometimes it is popularity that gives the advantage, perhaps best demonstrated by companies such as REA Group (REA) and Seek Limited (SEK). Buyers go to these sites because a lot of products are listed, and vendors list lots of products because lots of buyers go there. It is a virtuous circle that creates a barrier to imitation.

Banks have it too; they are entrenched in our daily lives. The personal cost to change PINs, passwords, accounts and cards is seen as outweighing the benefits gained from changing. The result is that banks can charge what they like and customers do not move.

 

Step four: Stick to businesses with high return on equity

There is no point in spotting a competitive advantage if it does not produce an attractive return on equity. Compare the ROE of the companies in your portfolio to the return on your equity from a bank account. Why own a business generating five per cent returns on the money you invested in it, with all the risks and stress, if a risk-free bank account will give you 7 or 8 per cent? Low rates of return destroy wealth, so the worst kinds of businesses are those that generate low rates of return on equity.

Look at businesses such as Cochlear, CSL, JB Hi-Fi, Commonwealth Bank and The Reject Shop; there is a strong relationship between share price performance over time and a sustained high rate of ROE. And watch out for debt. High levels of borrowing can make return on equity look artificially good.

 

(Note: these are not share recommendations, just examples of companies with a higher return on equity).

 

Step five: The intrinsic value formula and safety margin

Finally, learn to value businesses. Buy the best and only when they are trading at a discount to your estimate of intrinsic value.

 

The basic formula is:

 

Intrinsic value = ROE / r x E

 

Where 'ROE' is return on equity, 'r' is the return you require for the risk of taking on the investment, and 'E' is equity.

 

Think of a bank account paying a flat 20 per cent a year, with $10 million in it. If I was happy with a 10 per cent return on my money each year, I could pay:

 

Intrinsic value = 20% / 10% x $10 million = $20 million

 

The same formula works on companies that pay all their earnings out as a dividend. A good example is Telstra, whose intrinsic value is around $3.00 a share on my calculations.

 

The complete intrinsic value tables, including those required to value companies that retain and compound their profit, are in my book Value.Able.

 

To get started, go through your portfolio now. Ask yourself if the companies you own are high quality, then establish whether they are trading at prices that represent fair value rather than being way overpriced (use the tables from my book). Consistently buy good businesses below value and continue to own them for as long as they remain good businesses and fair value, and you cannot help but do well.

 

 

Roger Montgomery shares his step-by-step guide to valuing the best stocks and buying them for less than they're worth in his new book, Value.able, available exclusively at www.rogermontgomery.com. Roger also shares his stock market insights at this blog http://blog.rogermontgomery.com

 

 

Investors should obtain relevant and specific professional advice before making any investment decision. The information contained herein does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision investors should consider, with or without the assistance of a licensed advisor, whether the information contained herein is appropriate in light of their particular investment needs, objectives and financial circumstances.

 

The articles herein contain the current opinions of the author only. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of the author.