Things every investor must know


  • Human Nature
    • Human nature has always been driven by fear & greed and it will continue to do so. How else can we explain the dotcom boom and it's subsequent bust? Or the market bottom of 2009.
  • Prediction is very difficult, especially if its about the future .
    • In my opinion, discounted cash flow is a futile exercise as it based on predictions and assumptions, which makes it highly susceptible to cognitive biases and subsequent errors.
    • One can look at the past performance of the company but no one has seen the future. As they say, past performance is not an indicator of future performance.
    • There is no denying that stock market is forward looking. The questions is - how much forward looking is it? Next quarter, next year? Certainly not next five years. For the long-term investor this is a good thing.
  • Bear and Bull market
    • There will be boom and there will be bust. Without a doubt, the stock market will go down and up. The unwise thing is to focus on the question of 'when' and 'how much'. The wise things is to focus on what will you do when it happens? (Hopefully, buy more of quality companies)
    • Every bear and bull market is different in its own way but humans for the love of classifications will continue to classify these with past bear and bull markets.
  • Quality
    • All companies are not created equal. There are good companies and there are so-so companies. Just like smart and hard working people with right attitude, good companies can take a blow or two and still survive and come out on top. Temporary distress or obstacles can provide excellent buying opportunities.
  • Buy and Hold
    • John Keynes said, "When the facts change, I change my mind. What do you do, sir?" We live in a constantly changing world. At some point of time, every industry and every company will face changing landscape. It is the ability to adapt to change (foreseen and unforeseen) that will keep companies from collapsing. In some sectors like technology, the pace of change is faster, hence the need to adapt faster. The point is that it is crucial to keep up with the company story.
  • Hot industry (Competition)
    • As Buffett and Peter Lynch often tout, competition kills profitability. High growth and hot industries attract a lot of competition which kills profitability. In the words of Peter Lynch, 'for every hot product in hot industry, there are 1000 MIT graduates figuring out how to make it cheaper in Taiwan'.

ARM (ARMH) - Nov 2014

Category - Fast grower (Hold)
Although its customers are in an highly cyclical industry I would classify ARM as a fast grower.

Business Characteristics
  • Semiconductor industry is a highly cyclical industry. 
  • Technology sector is marked a rapidly and constantly changing arena. Introduction of a better mobile/non-mobile processor intellectual property or fundamental shift chip design can make the current product obsolete. 
About
ARM (British company) develops the blueprints that allow chipmakers (Qualcomm) to design their semiconductors. ARM's intellectual property has expertise in low-power high-performance chip architectures. It makes money on it's IP through up-front licensing fees and on-going revenue based on the price of each ARM-based chip sold. Its customers are semiconductor companies, original design manufactures and foundries.

Revenue - Breakdown
More than 75% of revenue comes from processor licensing and royalty fees.

Competitive advantages
  • Intangible assets (Intellectual property for processor design) 
  • Switching cost 
    • For chipmakers to abandon ARM's architecture and build a new one from scratch would require substantial investment. 
  • Stickiness 
    • Strong network of handset firms, chipmaker (Qualcomm), software providers (iOS and Android) and software developers around ARM-based designs increase ARM's stickiness.
  • Diversification 
    • ARM has also made major stride into non-mobile like networking and TV set top box chips. 
    • Broadcom using ARM based chips for their latest products. Texas Instrument's 32 bit microcontroller's are based on ARM's non-mobile designs. 
Threats
Increasing competition from Intel (Atom platform) as it tries to enter mobile chip market. Intel has made substantial progress in reducing the energy usage of its high-horsepower x86 chips.
Trends/Changing landscape
  • The growing use of high-end smartphones and connected devices is expected to be beneficial for ARM.
    • The total smartphone unit sales is projected to grow at 10% annually. 
  • Growth of smart non-mobile devices such as automobiles and connected home products is likely to benefit ARM so apps previously developed for smartphones/tables can be easily migrated to these products. 
News
At the end of third quarter (2014), the average royalties per chip slid to $.045 from $.049 a year ago.

Growth
  • Rise of low-end phone and competition in mobile processor arena likely to result in slower revenue growth due to lower prices and royalties for ARM. 
Revenue
The following graph outlines the revenue growth of ARM (ARMH) in the last 10 years. 


In the last 10 years, the total revenue has increased at an average of 18.22% and at a CAGR of 12.43%. Meanwhile, revenue per share has increased at an average of 13.75% and at a CAGR of 13.03%. 

Earnings growth (absolute)
In order to arrive at the owner's earnings, the 'Depreciation, Depletion and Amortisation' expenses have been added back to the 'Net income'. 

The table below shows the owner's earnings in the last 10 years for ARM (ARMH).

In the last 10 years, the earnings have increased at an average of 14.37% and at a CAGR of 10.24%. Due to the effect of share dilution, earnings per share has increased at an average of 10.38% and at a CAGR of 9.30%
ARM (ARMH) has delivered an annualised return of 20.48% vs 7.17% annualised S&P 500 return. 

Earnings vs Expenditure
In the last 10 years, ARM (ARMH) has spent an average of 62% of its owners earnings on capital expenditure.

                       

Dividends
In the last 10 years, the dividends have increased at a CAGR of 23.55%.
                      

Due to the effect of share dilution, dividend per shares on the other hand has grown at an average of 22.92% and at a CAGR of 20.23%. A CAGR of 20.23 implies, dividends doubling every 3.5 years.

The dividend payout ratio is 20.6% of its total cash earnings.

Share buybacks
The graph below outlines the total amount of money ARM (ARMH) has spent on buybacks.

                    


This demonstrated management focus on creating shareholder value.
ARM (ARMH) has increased the count of number of outstanding shares from 345 million in 2004 to 472.6 million as of Sep 14.

Total shareholders value
The graph below outlines the total amount ARM (ARMH) has returned back to shareholders in the last 10 years through dividends and share repurchases.

                     


On an average ARM (ARMH) has been able to return 25% of its total owner's earnings to shareholders through dividends and share buy backs.

Financial strength (Balance sheet)
The total liability to earnings ratio is 2.08 which is quite good and meets my investment criteria.

Expectation
Although ARM is a healthy company, but it carries a lofty valuation and personally, I would not invest at this level.

Peter Lynch - Pearls of wisdom

Peter Lynch is a legendary investor of all times who needs no introduction. He is probably best known for his mantra - 'Invest in what you know'. He has always been a great source of knowledge and inspiration for me. In this day and age, when investors are surrounded by a lot of noise, his remarkable talk from 1994 comes as a great refresher to ignore the noise and stick of fundamentals of investing.

Core Lab (CLB) - Oct 2014

Category - Cyclical
Core Lab provides services to oil field companies. The fate of the oil field companies is tied to the price of oil and the fate of Core Lab is tied to the fate of its customers (oil field companies). The price of oil moves in cycles of demand and supply and is cyclical in nature.

Business Characteristics
A reservoir has three components, namely,
  • The qualities of the rock 
  • How the fluids (oil, natural gas, and water) will flow through the rocks over time 
  • How to prevent and mitigate damage to the reservoir. 
Core Lab provides all of the three services both on a piecemeal and an integrated solution basis.

About The company provides descriptive analysis of the geological and fluid characteristics of reservoirs to oil companies which in turn helps them increase production. The company operates in more than 50 countries and has more than 5,000 employees.

Revenue - Breakdown
  • Deep water oil production (20%) 
  • International oil production (>50%) 
Competitive advantages
  • Core Lab holds a niche position in the oil field company. 
  • Core Lab generates highest return on capital in the oil services industry. 
  • Intangible asset 
    • The firm has accumulated decades of of geological data, built considerable knowledge within its workforce and developed numerous proprietary processes and products.
  • Network effect 
    • The firm benefits by performing multi-client reservoir characterisation studies. The more customers it serves, the more robust the data set and the valuable the study is for all customers. 
  • Barrier to entry 
    • Working with multiple clients across the globe, the accumulated knowledge and capabilities provides a barrier to entry against its competition. 
    • It is the only independent services company in the world to offer these services globally. 
Threats
  • Prolonged period of lower oil prices. 
    • The firm concentrates its services on improving production and reservoir recovery, instead of exploration. 
Trends/Changing landscape
  • Greenfield oil reserves have become more difficult to find and costly to extract, leading to both independent and state-owner oil companies to spend more on maximising production at mature fields. 
  • Falling oil prices would put pressure on spending budgets of oil producers implying lower to negative revenue growth for Core Lab. 
News
  • Core Lab failed to meet the revenue guidance given by the management in the prior quarter. 
  • Core analysis projects in the Gulf of Mexico are experiencing delays. 
  • Slowdown in the core and fluid activity 
  • Operating margin improved to 33% by 190 basis points 
Growth
The growth in the next couple of years is likely to remain weak to negative due to falling oil prices.

Eaton Vance (EV) Analysis - Oct 2014

Category - Cyclical 
  • AUMs enter the market during bull market (economic growth, rising stock market etc) and exit the market during bear market, this attributes to cyclical nature of earnings. 
Business Characteristics 
  • Switching cost and intangibles asset provide most durable competitive advantages across the asset management industry. 
    • Switching cost 
      • Given the lack of clarity around the benefits of moving asset to another asset management company, most customers tend to stay with the current company. 
      • This advantages can be further amplified by the asset management companies through product mix, distribution channel concentration, geographic reach and intangible assets like brand name. 
    • Asset stickiness 
      • Being a diversified asset manager allows companies to better hold on to assets during turbulent market conditions. 
About
It is a leading issuer and manager of closed-ended funds. Eaton Vance makes money by charging fees on assets-under-management (AUMs). 

AUM - Breakdown
  • Equity (33% of AUM) 
  • Equity related implementation services (33%) 
  • Fixed income (15%) 
  • Floating rate bank loan (14%) 
  • Alternative asset (4%) 
  • Money market funds (remainder) 
Competitive advantages
  • Niche (tax sensitive clients) 
    • It provides equity and fixed-income investments to tax-sensitive clients. 
  • Stickiness 
    • Fairly diverse range of AUMs, which tend to be stickier during turbulent market conditions. 
    • A focus on closed-ended funds and tax-managed investments help attract and retain sticky funds. 
  • Strong brand name 
Threats
Growing popularity of passive investment vehicles (ETFs)

Trends/Changing landscape 
  • Bush era tax-cuts expired at the end of 2012. 
  • As interest rates rise, the fixed-income AUMs are expected to decline. 
News
  • In July 2012, the company invested 190 million for 49% stake in Hexavest (Cannadian asset manager - long only equity investment) 
  • In 2013, EA acquired Clifton Group, provider of futures-and-options based overlay services. 
Growth
  • EA posted 12% organic revenue growth of assets-under-management (AUM). 
  • Launched several closed-ended funds. 
  • As interest rates rise, the floating-rate bank loan funds are expected to rise moderatly. 
  • Growth in equity related implementation services (33% of total AUM) likely to have marginal positive impact on revenue due to lower fees associated with implementation services AUM. 

Western Union (WU) - October 2014

Overview
Denver-based Western Union is the world's largest money-transfer company, spin-off from First data FDC in 2006. The company's agents provide other financial services, including check cashing, bill payment, prepaid cards, and money orders. Its customer base is immigrants who send money to their home countries.

Competitive advantages
  • Size: WU handles approx. 20% of international money transfer transactions vs. MoneyGram MGI, the company's closest rival, controls about 3% of the market. Its operating margins are twice that of its closest competitor.
  • Network: Network of worldwide agents covering 40 countries and 120 currencies. Its network has grown from 271,000 agents in 2006 to 500,000 agents in 2014.
  • Brand: Recognised brand and trusted brand.
Risks
  • Alternative methods of payments: Main fears surrounding the company is that the business model looks potentially obsolete given the global trend toward electronic payments. 
  • Western union is prone to regulatory risks as regulators closely monitor for any illegal money transfers.
Acquisitions Trends
  • Acquired Custom House in 2009.
  • Acquired the global business payments division of Travelex Holdings Limited Trends in 2011.
Negative Trends
  • Securities and Exchange Commission is investigating claims by former employees of Western Union that the company has misrepresented the performance of its digital unit.
  • Increase in compliance cost: This is a mixed development as increasingly complex compliance environment could create higher barriers to entry and Western Union is likely better positioned to absorb these changes over time than its smaller peers. 
  • Increasing competition in online money transfer services with the Facebook, Xoom and Walmart entering the money transfer market. One point worth noting is that Western Union’s growth in electronic channels continues to exceed the growth of Xoom, a purely electronic competitor. 
  • Loss of about 7,000 agents in Mexico due to compliance issue, permanently dmaging its position in this corridor in the year 2012.
  • Operating margin has been under pressure in the last few years.
Positive Trends
  • Strong growth in non-cash based transfers. As noted earlier, it's growth in electronic channels continues to exceed the growth of Xoom, a purely electronic competitor.
  • Money transfer segments aimed at Asia is growing rapidly but only accounts for less than 10% of total revenue.
Revenue
The following graph outlines the revenue growth of Western Union (WU) in the last 10 years.
The revenue for Western Union has more or less remained stagnant in the range of 5 to 5.5 billion range. Between Jan-05 and Jan-13 the revenue grew at a CAGR of 4.20%.

Earnings growth (absolute)
In order to arrive at the owner's earnings, the 'Depreciation, Depletion and Amortisation' expenses have been added back to the 'Net income'.


The table below shows the owner's earnings in the last 10 years for Western Union (WU).
Not surprisingly, the earnings pattern is also quite similar to that of revenue pattern with no growth (CAGR of .66%) in earnings in the last 8 years. 

As a result of depressing valuation (mostly at a PE of less than 14) and share buyback program, WU has been able to grow the earnings per share (EPS), at a mediocre CAGR of 4.12%.

Earnings vs Expenditure
In the last 10 years, Western Union (WU) has spent an average of 25% of its owners earnings on capital expenditure.

Over the last 10 years, WU has spent a total of $1.8 billion on acquisitions. As is evident from the earnings growth chart a more prudent use of that capital would have been to return it to shareholders.

Dividends
In the last 6 years, the dividends have increased at a CAGR of 44%. Future dividend growth is very likely to be within 5-7% growth rate as the dividend payout ratio creeps up. 

The dividend payout ratio is 25% of its total cash earnings.

Share buybacks
The graph below outlines the total amount of money Western Union (WU) has spent on buybacks.
This demonstrated management focus on creating shareholder value.

Total shareholders value
The graph below outlines the total amount Western Union (WU) has returned back to shareholders in the last 10 years through dividends and share repurchases.
On an average Western Union (WU) has been able to return 60% of its total owner's earnings to shareholders through dividends and share buy backs.

Expectation
Western Union earnings growth is likely to remain stagnant in both near and long term future. In my opinion, WU's depressing valuation (the more depressed the valuation, the greater the effect of buy backs) and its market leader status makes this an attractive company.

Valuation
The current market cap for Western Union (WU) stands at $8.6 billion and at a trailing P/E of 11.30. At current share price ($16.17) WU delivers a dividend yield of 3% and shareholders earnings yield of 7%.

Based on my valuation, I believe Western Union is currently reasonably priced at $16.17 for long term investment.

Gap Inc. (GAP) Stock Analysis - 2014

Overview

Founded in 1969, Gap Inc., is a specialty retailer offering clothing, accessories, and personal care products for men, women, children, and babies under the Gap, Old Navy, Banana Republic, Piperlime, and Athleta brands. 
  • It entered the children's apparel market with the introduction of GapKids in 1986 and BabyGap in 1989. 
  • It launched GapBody in 1998 offering women's underwear, sleepwear, loungewear, and sports and active apparel. 
  • It launched Old Navy in 1994 to address the market for value-priced family apparel. 
  • It launched Piperlime in October 2006 and acquired Athleta in September 2008.
It operates stores in the United States, Canada, the United Kingdom, France, Ireland, and Japan, while its independent third-party franchisees own and operate stores in Asia, Europe, Latin America, and the Middle East under the Gap and Banana Republic brand names. 

As of February 1, 2014, Gap Inc. (GPS) had a workforce of approximately 137,000 employees.

At the end ended fiscal 2013 with 3,539 Company-operated and franchise store locations.

Revenue
The following graph outlines the revenue growth of Gap Inc. (GPS) in the last 10 years.
As you can see from the graph above, revenue declined between 2005 and 2010 and then increase again between 2010 and 2014. Overall, the revenue hasn't grown in the last 10 years.

Consumer purchases of discretionary items, including merchandise, generally decline during periods when disposable income is adversely affected or there is economic uncertainty, which is confirmed by the drop in revenues during the year 2009, when GFC (Global financial crisis) hit the world and consumer spending was at its lowest.

In addition, Gap Inc. (GPS) operates in a business that follows a seasonal pattern, with sales peaking over a total of about eight weeks during the end-of-year holiday period.

Over the past 24 months, reported monthly comparable sales have ranged from an increase of 10 percent in July 2012 to a decrease of 3 percent in September 2013. Comparable online sales favourably impacted total Company Comp sales by 3 percent and 2 percent in fiscal 2013 and 2012, respectively.

In fiscal year 2013, the company opened 190 Company-operated stores, primarily through expansion in Asia. Specifically, Gap Inc expanded store base in China, opening 34 stores for a total of 81 specialty and outlet stores, and opened an additional 17 Old Navy stores in Japan for a total of 18 stores. The company opened 58 global outlets for a total of 532 outlet stores. It also opened 30 Athleta stores, ending fiscal 2013 with 65 Athleta stores. The franchisees added 72 new stores and five new markets.

In fiscal 2014, the company expects net openings of about 115 Company-operated store locations.

Earnings growth (absolute)
In order to arrive at the owner's earnings, the 'Depreciation, Depletion and Amortisation' expenses have been added back to the 'Net income'.

The table below shows the owner's earnings in the last 10 years for Gap Inc (GPS).
As the graph indicates, the earnings haven't grown much in the last decade. In the last 10 years, the earnings have increased at an average of 1.44% and at a CAGR of .29%,which puts it in under 'No growth' category. 

Due to the effect of share buyback program, the earnings per share (EPS) has grown at an average of 11.65% and at a respectable CAGR of 9.51%.

The Gap Inc. has delivered an annualised return of 9.21% vs 6.97% annualised S&P 500 return.

The business is vulnerable to changes in fashion trend and consumer taste and to suboptimal selection and timing of merchandise purchases. The inventory levels build up prior to peak holiday selling season. If sales do not meet expectations, too much inventory may cause excessive markdowns and, therefore, lower than planned margins, thereby impacting earnings.

Earnings vs Expenditure
In the last 10 years, Gap Inc. has spent an average of 35% of its owners earnings on "Property, plant and equipment'. 

The graph below outlines the 'Earnings vs Expense' ratio in last 10 years.
The management team has been quite prudent at making acquisitions, instead of going on a buying frenzy to raise revenue they have been quite focused on making good deals. Gap Inc. has spent a total of $129 million on acquisition and purchase of business in last 10 years.

Dividends
GPS has increased dividends for 10 years in a row, which satisfies one of my investment criteria.

The graph below outlines the dividend growth rates in the last 10 years.
In the last 10 years, the dividends have increase at an average of 22.14% and at a CAGR of 16.86%, these number are skewed due the sharp rise in dividend payment in jan-06.

Due to the effect of share buybacks, dividend per shares on the other hand has grown at an average of 25.44% and at a CAGR of 22.83%. A CAGR of 22.83 implies, dividends doubling every 3.5 years, these number are skewed due the sharp rise in dividend payment in jan-06.

The dividend payout ratio is 17% of the total cash earnings.

Gap Inc. (GPS) paid a dividend of $0.70 per share for fiscal 2013. The company intends to increase the annual dividend to $0.88 per share for fiscal 2014.

Share buybacks
The graph below outlines the total amount of money Gap Inc. (GPS) has spent on buybacks.
In January 2013, the Board of Directors authorised $1 billion for share repurchases, which was fully utilised as of February 1, 2014.

In November 2013, Gap Inc. (GPS) announced that the Board of Directors approved a new $1 billion share repurchase authorisation, of which $966 million was remaining as of February 1, 2014.

Gap Inc. (GPS) has been able to bring down the total outstanding shares from 991 million to 467 million in 2014, thereby reducing the total outstanding shares by more than 50%

This demonstrated management focus on creating shareholder value.
Total shareholder value
The graph below outlines the total amount Gap Inc (GPS) has returned back to shareholders in the last 10 years through dividends and share repurchases.
On an average GAP Inc. (GPS) has been able to return 65% of its total owner's earnings to shareholders through dividends and share buy backs.


Financial strength (Balance sheet)
The total liability to earnings after capital expenditure is 4.30 which is quite good and meets my investment criteria. 

Potential risk
  • Dependence on china for merchandise: Approximately 28 percent of purchases, by dollar value, are from factories in China.
  • Due to the nature of fashion business, it requires anticipating and quickly responding to changing apparel trends and customer demands.

Valuation
The current market cap for Gap Inc. (GPS) stands at $18.47 billion and at a trailing P/E of 16.30. At current share price ($41.91) Gap Inc. (GPS) delivers a dividend yield of 2.10% and shareholders earnings yield of 5.69%.

Based on my valuation, I believe Gap Inc. is currently reasonably priced at $41.91 for long term investment.

What I look for in a Company

Companies I avoid
  • Companies that do not yet generate income.
  • For some businesses, it takes money to make money. These businesses usually have huge capital spending requirements before they can generate income. A usual characteristic of such a business is that cash expenses exceed the cash income.
  • Companies that are notorious for diluting shareholders equity by selling extra stock to raise cash. For e.g. REIT.
  • Companies that are in early growth phase where they are deploying most of their earned income back into business. This one might seem controversial. These are usually fast growers and trade at a premium (high PE ratios). The trouble starts when these companies hits a road block or saturation point or encounter one bad earnings season. Within a matter of few days they can lose as much as 30-50% of their value. As mentioned in my earlier post I am not adept at identifying such scenarios and would rather avoid them. E.g LULU, SODA.
  • Companies where management is not focused on creating value for shareholders. For instance, Apple, an extremely profitable enterprise - until recently was sitting on ridiculous pile of cash and would not return the cash to shareholders. Microsoft exhibited the same behavior until 2003. May be the reason such companies prefer to sit on piles of cash is that they operate in fast changing/ rapidly evolving industries and management finds it comforting to sit on piles of cash rather than distribute it. Interestingly enough,I often find companies that meet all of my investment criteria except this one.
Is my 'avoid' checklist perfect? Off-course not. Does it also end up eliminating awesome businesses? I am sure it does, but then again you can't kiss every pretty girl.

Companies I seek

  • Companies that have an history of generating profits for at least 10 years. Why ten years? Ten years is usually long enough period to cover one economic cycle. This is vital piece of information as it provides insights into how economic downturns impact the companies earnings capability. 
  • Businesses that require little money to make money. A usual characteristic of such a business is that their cash expenses are way lower their cash income. Phillip Morris, Kellogg and Coke are some of the very well documented companies.
  • Companies that are in mature phase where they are ploughing only a part of their earned income back into business. These are companies that generate enough income to expand their business without needing to raise cash by selling more stock.
  • Companies where management is focused on creating value for shareholders, through dividends and/or buybacks.
  • Companies that have raised their dividends for at least 10 years in a row. An organization's earnings don't always move up in a linear fashion. Almost every company inevitably goes through challenging times and their earnings are negatively impacted. The trouble(s) plaguing the company can either a temporary one or a severe blow that will be detrimental to future prospects of the company. At this critical juncture, an investor is required to make a 'sound' judgement call whether to exit the position, hold on or to add further. Additionally, the hoopla created by the media added to the mix, I find my ability to make a 'sound' judgement call severely impaired. This is where dividend raises come into picture. I use them as an indicator to assess whether the trouble company is facing is temporary or long lasting.
Is my 'seek' checklist perfect? Off-course not. Does it also end up including awful businesses? I am sure it does, but hopefully the winners will outweigh the losers (handful of quality investment is all you need for a lifetime of financial freedom).

Undoubtedly, I will make mistakes along the way but I hope to learn from my mistakes and continue to build my knowledge.

Foundation of my Investment Criteria

I like to think of myself as a 'Value investor'. This is not to say that I avoid growth companies, it implies that I am not willing to pay a fortune in high fliers. In simple terms, I look for value regardless of how a company is categorized.

I believe that every investor is different, and have unique goals and circumstances. No one particular investing style/strategy fits all investors because there are too many variables involved.

Let me bring up an example to demonstrate my point, Warren Buffet has often said - "You should approach investing like you have a punch card with 20 punch-outs, one for each trade in your life. I think people would be better off if they only had 10 opportunities to buy stocks throughout their lifetime." Contrast that with Peter Lynch -"I've always believed that searching for companies is like looking for grubs under rocks; if you turn over 10 rocks you'll likely find one grub; if you turn 20 rocks you'll find two. The person that turns over the most rocks wins the game. And that's always been my philosophy." Not surprisingly, Peter Lynch at one point of time had has more than 1,500 stocks in his portfolio. While Warren Buffet has very low turnover in his portfolio, Peter Lynch often bought and sold stocks on a daily basis.

This does not make any one of them right or wrong, both of them are one of the greatest investors of our time. The point I am trying to demonstrate is - one of the most important task for an individual investor is to ensure that he learns about different investing strategies and chooses the one that fits within his intellectual/philosophical framework.

As an investor it is of paramount importance that we all understanding our shortcoming and limitations. Below is my attempt at understanding and articulating my shortcoming and strengths.

Shortcomings
  • I do not have the capability to time the market.
  • Identifying the strongest business with favorable economic characteristics and wide moats is not one of my strength. For the sake of argument let us assume that I could find a business that I both understood, had favorable economic characteristic and a wide moat. I would still need to arrive at a price at which that investment makes sense, which bring me to the next point.
  • Valuing a business in absolute range of dollar value is also not one of my strengths. Charlie Munger/Warren Buffet has often said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.' This requires one to be able to first identify a wonderful business and second arrive at a fair price through valuation.
Strengths
  • I believe that time in the market is more important that timing the market. There is no doubt that I would have been better-off starting investing earlier in my life. As they say, 'Time is on your side when you invest for the long term', I still have a good 35 years before I reach the 'official' retirement rate.
  • I have a strong stomach to ride the ups and downs of the market. In the words of legendary investor Peter Lynch - ”Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed.  It isn’t the head but the stomach that determines the fate of the stock-picker. Everyone has the brain power to make money in stocks. Not everyone has the stomach.
  • Like most of the humanity I am fairly good at relative valuation. Research has shown that people are better at estimating relative sizes (A – C is twice as far as A – B, Basket X is about 1/3 the weight of Basket Y) than coming up with absolute estimates (A to B is 15km, Basket X is 7.5kg). I find relative valuation much quicker; and I need less information to get started.
  • I am a voracious reader have a strong inclination to learn.
One important thing to note is that I do not take these shortcomings as immutable. By continuously learning about investing I aim to slowly and gradually overcome my current shortcoming and strengthen my strengths.

I do not have any lump-sum money to invest. I work in a full time job and have used all of my saving so far in the purchase of my home (mortgage). My investment savings come from my monthly paycheck. I have concluded to invest in market on monthly basis. This decision has more to do with my current circumstances, although it does effectively put me under the dollar cost averaging camp. I do, however, understand that there are arguments both in favor of and against dollar cost averaging.

International Business Machines (IBM) Analysis - Oct 2014

Category - Slow grower
Revenue is likely to stay flat in coming years.

Business characteristics
  • The technology (both software and hardware) sector is marked by a constantly changing arena, IBM will need to adapt to changes in addition to fighting competition. 
  • IBM's strategy is to adapt to changes in the tech arena by getting out of lower-end business and making a foray into software and higher-value services with a focus on cost reduction through acquisitions. 
About
Its in the enterprise software, services and hardware business and is an industry leader in each of its businesses. 

In the early 1990s, IBM started moving away from its reliance on mainframes towards software and higher-value services with a focus on cost reduction. 

The company creates business value for clients and solves business problems through integrated solutions that leverage information technology and deep knowledge of business processes. IBM solutions typically create value by reducing a client's operational costs or by enabling new capabilities that generate revenue.

IBM has a significant global presence, operating in more than 175 countries, with an increasingly broad-based geographic distribution of revenue.

The company continues to invest to capture the long-term opportunity in markets around the world that have market growth rates greater than the global average—countries within Southeast Asia, Eastern Europe, the Middle East and Latin America.

The company's major markets include the G7 countries of Canada, France, Germany, Italy, Japan, the United States (U.S.) and the United Kingdom (UK) plus Austria, the Bahamas, Belgium, the Caribbean region, Cyprus, Denmark, Finland, Greece, Iceland, Ireland, Israel, Malta, the Netherlands, Norway, Portugal, Spain, Sweden and Switzerland.

In 2013, IBM was awarded more U.S. patents than any other company for the 21st consecutive year.
Revenue
  • System hardware - 14% 
  • Infrastructure software - 25% 
  • Outsourcing and Systems integration - 60%. 
Competitive advantages
  • Software and services business has a high switching cost. 
  • Sticky - Reoccurring revenue stream. 
    • As an example, migrating mainframe based application to alternative architecture can be expensive and risky. 
    • When considering infrastructure-management software, IT personnel rely on it to operate their data centres and are reluctant to switch to new, less familiar systems. 
Threats
  • Cloud computing (Hardware): With computer resources increasingly delivered by cloud providers, demand for IMB's high-end servers could weaken. 
  • Cloud computing (Software): As software-as-a-service gains wider adoption, demand of IBM software could weaken. 
Competition
  • IBM is facing increasingly competitive pressure from Oracle and Cisco in hardware segment from commodity x-86-based servers. 
  • Custom software development approach being challenged by Oracle's cheaper integrated solutions that aims to meet 80% of customer requirements. 
  • Big data is a hot and growing industry with fierce competition. 
Shareholder return
Dividends: The company has increased dividends for 19 years in a row. The current payout ratio is 25%.

News 
  • IBM has shed roughly $7 billion in low-margin revenue through its recent divestitures of its customer care, System X and microelectronics businesses. 
  • The company sees weaker demand profile and plans to restructure of its workforce. 
  • Apple and IBM announced an exclusive partnership to further promote and deliver iOS to the enterprise customer with IBM developing and selling big data and analytics apps for the iOS platform. 
Growth
  • Mainframe markets is unlikely to grow, but will continue to provide steady flow profits. 
  • Revenue growth is likely to stay flat in coming years.
Earnings growth (absolute)

In order to arrive at the owner's earnings, the cash based 'R&D' expenses and non-cash 'Depreciation, Depletion and Amortisation' expenses have been added to the reported Net Income.

The table below shows the earnings in the last 10 years.


In the last 10 years, the absolute earnings have increased at an average of 4.19% and at a CAGR of 4.12%, which puts it in under 'Slow growers' category.

Due to the effect of share buybacks, the EPS on the other hand has grown at an respectable average of 14.78% and at a CAGR of 16.61%.


Earnings vs Expenditure
In the last 10 years, IBM has spent an average of 48% of its owners earnings on 'R&D', 'Property, Plant and Equipment' and 'Purchase of business'.

I would like to explain my rational behind treating 'R&D' as an expenditure. As a general rule of thumb, the accounting standards dictate that companies aren't allowed to capitalise their research and development cost and is instead treated as an expense which is in contrast to how the cost on 'Property, Plant and Equipment' is treated. The main reason behind it is that there's no way to reliably measure the future economic benefits of R&D costs. 

However, companies invest in R&D for the same reason as they invest in other capital expenditure - to grow/expand the business and remain profitable. Hence, in my analysis I add the 'R&D' expenses and other capital expenditure to arrive at owners earnings. Subsequently, I deduct any cost spent on 'R&D', 'Property, Plant and Equipment' and 'Purchase of business' as capital expenditure.

The graph below outlines the 'Earnings vs Expense' ratio in the last 10 years.


Dividends
IBM has increased dividends for 18 years in a row, which satisfies one of my investment criteria.

The graph below outlines the dividend growth rates in the last 10 years.

In the last 10 years, the dividends have increase at an average of 15.15% and at a fantastic CAGR of 14.78%. Due to the effect of share buybacks, dividend per shares on the other hand has grown at an average of 20.76% and at an extraordinary CAGR of 20.32%. A CAGR of 20.32 implies, dividends doubling evert 3.5 years.


Share buybacks
The graph below outlines the total amount of money IBM has spent on buybacks.
IBM has been able to manage to bring down the total number of outstanding shares (diluted) from 1,707.2 million in 2004 to 1005.1 million in 2014, thereby reducing the total outstanding shares by whooping 41%.

This demonstrates the management's focus on creating value for the shareholders.

Total shareholder value
The graph below outlines the total amount IBM has returned back to shareholders in the last 10 years through dividends and share re-purchases.

On an average IBM has been able to return 50% of its total owner's earnings to shareholders through dividends and share buy backs.

Financial strength (Balance sheet)
The total liability to earnings after capital expenditure is 6.24 which is phenomenal.

Long term outlook
IBMs strategy is to focus on
  • Big Data: The company has invested more than $22 billion, including $15 billion on more than 30 acquisitions, to build its capabilities in big data and analytics. 
  • Cloud computing: The company has invested over $6 billion to acquire more than 15 companies related to cloud, and is investing more than $1 billion to expand its global footprint to 40 datacenters worldwide. IBM now has more than 100 SaaS offerings, and IBM cloud supports 24 of the top 25 Fortune 500 companies. 
  • Systems of engagement: IBM has acquired 20 companies related to mobile, social and security. IBMers are collaborating in more than 200,000 internal social communities and 85 percent of IBM's sellers use the company's Sales Connect portal. 
Risks
Acquisitions, Alliances and Dispositions include Integration Challenges, Failure to Achieve Objectives, and the Assumption of Liabilities. Acquisitions often (two-thirds) fail to deliver the financial benefits that are envisaged.

ExxonMobil Corp. (XOM) Stock Analysis

Overview
Exxon Mobil Corporation, a New Jersey corporation was incorporated in 1882. The Company's main business is energy, involving exploration for, and production of, crude oil and natural gas, manufacture of petroleum products and transportation and sale of crude oil, natural gas and petroleum products. It is also a manufacturer and marketer of commodity petrochemicals, including olefins, aromatics, polyethylene and polypropylene plastics and a wide variety of specialty products. 

Earnings growth (absolute)
In order to arrive at the owner's earnings, I have added the Depreciation, Depletion and Amortisation' expenses back to net income.
The table below shows the earnings in the last 10 years.
In the last 10 years, the absolute earnings have increased at an average of 7.58% and at a CAGR of 3.55%, which puts it in under 'Slow growers' category.
Due to the effect of share buybacks, the EPS on the other hand has grown at an average of 13.38% and at a CAGR of 6.60%.


Earnings vs Expenditure 
In the last 10 years, XOM has spent an average of 40% of earnings on capital expenditures. The capital expenditure includes amount spent on 'Purchase of property, plant and equipment'.

Dividends
XOM has raised dividends for 31 years in a row, which meets my investment criteria.
The graph below outlines the dividend growth rates in the last 10 years.
In the last 10 years, the dividends have increase at an average of 6.34% and at a CAGR of 4.6%. Due to the effect of share buybacks, dividend per shares on the other hand has grown at an average of 9.88% and at a CAGR of 8.8%.

Share buybacks
The graph below outlines the total amount of money XOM has spent on buybacks.
Although, XOM is involved in an industry with heavy capital expenditure, it hasn't raised cash by offering shares, which would have resulted in share dilution. Instead, XOM has been able to manage to bring down the total number of outstanding shares (diluted) from 6,511.6 million in 2004 to 4,297 million in 2013.
This demonstrates the management's focus on creating value for the shareholders.


Total shareholder value
The graph below outlines the total amount XOM has returned back to shareholders in the last 10 years.
On an average XOM has been able to return 57% of its total owner's earnings to shareholders through dividends and share buy backs.

Financial stability (Balance sheet)
The total liability to earnings after capital expenditure is 5.59 which is phenominal. 

Long term outlook
By 2040, the world’s population is projected to grow to approximately 8.8 billion people, or close to 2 billion more than in 2010. Even with significant efficiency gains, global energy demand is projected to rise by about 35 percent from 2010 to 2040. Substantial efficiency gains are likely in all key aspects of the world’s economy through 2040, affecting energy requirements for transportation, power generation, industrial applications, and residential and commercial needs

Potential risk
The oil, gas, and petrochemical businesses are fundamentally commodity businesses. This means ExxonMobil’s operations and earnings may be significantly affected by changes in oil, gas and petrochemical prices and by changes in margins on refined products.

The demand for energy and petrochemicals correlates closely with general economic growth rates. The occurrence of recessions or other periods of low or negative economic growth will typically have a direct adverse impact on earnings. As noted in the year 2009, the global economic environment can impact its growth and profits when earnings took a hit.

The growth in alternate sources of energy 

Valuation
The current market cap for XOM stands $421 billion and at a trailing P/E ratio of 12.60. At current share price ($98.73) XOM delivers a dividend yield of 2.70% and shareholders earnings yield of 7.54%.

Based on my valuation, I believe XOM is currently attractively priced at $98.73 for long term investment.

You can see my portfolio here

* All numbers are in millions
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