Good Business and Good People are the only two measurements of security selection. Good Price is the time selection. Good Business > Good Price > Good People.
Three Basic Laws
- (Graham) “The intrinsic value equals to the assets of the company” OR (Buffett) “The intrinsic value equals to the future free cash flow of the company”
- Uncountable parameters compose the stock market. Mr. Market is a psycho. His behavior is unpredictable but the investor can take advantage of it.
- Safety margin.
For good business, the qualitative evaluation is prior to quantitative evaluation. The results of the evaluation should be a range of intrinsic value instead of overfitting a narrow model.
An industry includes many businesses. For example, IM, SNS, E-commerce, and searching engine are included in the internet industry. However, one business can be included in more than one industry. For example, E-commerce can be included in either the internet industry or the retail industry. Moreover, one business includes one or more business models. For example, for E-commerce, there are :
- online retailer
- Directly sell the goods, revenue come from the profit of goods, Big B to C
- jd.com, amazon.com (before the entry of third-party seller), relentless.com
- Making the platform for small business to sell the goods, revenue comes from advertisement, Small B to C
- taobao.com, pinduoduo.com
- single brand online retailer,
- and marketplace
- Making the platform for individuals to sell the goods, revenue comes from the trading fee, C to C
Business like people because they are naturally unequal. Same as someone is the only son of a billionaire, some business can make the consistent profit much easier than others. For example, searching engine is a naturally monopoly business, the first place can take more than 80% market share; moreover, the searching engine has negligent marginal cost, so the generate consistently or even increasingly free cash flow without extra input. Instead, the automaker company is not monopoly due to the diversified taste of customers, unable to generate consistent cash flow due to the strong correlation between automaker business and credit cycle, and unable to generate remarkable free cash flow due to the high CapEx and high marginal cost.
For positive net income companies:
- Is the net Income from main businesses real?
- Except for the insurance company and the investing company, the main business is not included investment.
- Is the net Income from main businesses consistent and continuous without the extra input?
- For developing or high pe company, is CAGR consistent?
- To analyze this question, the investor has to understand the essence of the business and identify the unique core competence of the company.
- Is the competition caused by outside capital possible to happen? How much is the influence of net income from main businesses from the competition?
- Capital always chases Cumulative Abnormal Return (CAR) until the CAR decrease to the normal rate of return.
- Business, has CAR, will cause (the Capital want to have a finger in the pie) the Capital to entry
- Only the moat can stop the outside Capital
- Different types of moats
- Genetically monopoly business, the business has the network effect, the Matthew Effect, or supply-side economies of scale.
- Special limited license，example: Indian casino
- The brand has a special place in customer’s mind, example: coke cola, Cheetos, and so on.
- The technological or patent barrier, example: Qualcomm
- The fake CAR
- The market of the business cannot accommodate outside capital, which means if more capital come in, no company can generate profit anymore.
- Buy the stock of the company in the market is much more economic than compete with the company.
- The same kind of moat has a different effect on different businesses. For example, both automaker and newspaper business has the supply-side economies of scale but the supply-side economies of scale of newspaper business has a better effect.
For non-positive net income companies
- Use the VC model to invest
- The unique and irreplaceable competence of the company.
- The celling of this business.
- The founding team.
Good people compose of the management and the company culture.
- Integrity is the prerequisite character.
- Is the relationship between the management and the company is sustainably mutually beneficial?
- The company culture
- Is the relationship between the company and the client is sustainably mutually beneficial?
- Is the relationship between the company and the employee is sustainably mutually beneficial?
- Is the relationship between the company and the shareholder is sustainably mutually beneficial?
- For the CEO, good character (integrity etc.) > good attitude (spend all energy and time in the work) > good ability (business genus)
- There are two premises,
- As a selected CEO or a founder, the ability has the bottom line
- The company is selected good business is prior than good people, so personal ability is not that important instead
- There are two premises,
- The security selection is universal to all the market
- All the above is a general outline. In practice, the general outline will have adjustment according to the specific case.
The intrinsic value calculated by the investor = IVI
The market value = MV = The intrinsic value calculated by the market = IVM
- Since nobody can efficiently predict the movement of the market.
- The investor only can use the IVI as the anchor to open the position.
- MV stands for the weighting summation of all IVIs. (more capital influences the market harder)
- For the good investor, they may have a different opinion with the market about the intrinsic value of a company.
- (IVI – MV) / IVI = x%
- x% + the growth of intrinsic value = the ROI for the investor of this stock
The definition of Good Price
- Current IVI + the Growth of IVI – Current MV = the ROI of the deal
- sqrt(x) of the ROI is the annual ROI, x is the # of years.
- Good Price represents that the annual ROI is more than the investor’s target annual ROI.
- The definition of good price is personalized due to the IVI is personalized
- Example: My target annual ROI is 25%. Momo current price is around 60b. Based on the analysis, Momo’s IVI will be 160b – 200b in the next five years. Thus, now, Momo has Good Price for me.
Why the gap between MV and IVI will be filled
- All of the capital are looking for a higher ROI but scare the risk.
- The free-risk interest rate is the benchmark.
- Security investment has a good return but too risky unless the value of the security is proved by the performance.
- Then, the security has no more risk but double or triple return than the free-risk interest rate.
- The capital flows into the security until that return is reduced to the free-risk interest rate.
- Above of all are the simplified model:
- In fact, investors buy at the predicted value based on the probability.
- The different IVI and target annual ROI cause the deviation of the simple model.
- For example, the capital may stop flowing into one security; even the return is double than the free-risk interest rate. The probability of this return may low; The shape ratio may not good enough.
The chosen of Good Price (target ROI)
- The difference between the IVI and the MV is the safety margin.
- The difference between the IVI and the MV is the return
- For example, Bob buys a stock at 10. Mia buys a stock at 5. When the stock increase to 20, Bob has a +100% return and Mia has a +300% return. When the stock decrease to 2.5. Bob has -75% return and Mia has a -50% return.
- Waiting for a better price will lose some opportunities.
- The chose of the target ROI of one security should be according to the circle of competence, the planning general ROI of the investor, the risk, and the trading strategy.
Good Price at selling
There are three situations to reduce the position of a stock
- The businesses of the company are not the good business anymore.
- All cash is equal. Another stock has better annual ROI, more certainty, and more negative correlation with main positions.
- For example, when 600900 is below than 14.5RMB, it has a close annual ROI but more certainty and more negative correlation with 600036. Thus I sell some 600036 and use the cash to buy 600900.
- The original opinion of the company is wrong.
When the 1st and the 3rd situations happen, the position of that stock should be reduced to 0.
When the 2nd situation happens, the position should be adjusted based on the specific case.
2) No leverage
The Drawbacks of Intrinsic value investing.
The cycle of value investing is normally more than years. (Why? review the Good price part)
Warren Buffet can use the value investing due to:
- Warren’s capital is not affected by yearly bad performance and big withdraw (pull back)
- Warren has float as the leverage which is low or even negative interest and will not be margin closeout.
But the current fund managers is hard to use it because their performance is concluded quarterly.
- They can not bear the big pullback quarterly. The investor may withdraw the capital, the floating loss transfers to permanent or actual loss.
- They do not have free leverage to amplify their performance.
- The Cumulative Abnormal Return reduces and becomes rare due to:
- The information on the company and industry is more accessible and comprehensive.
- More capital started to invest based on fundamental analysis.
- The capital of institutional investor is occupying bigger market portion.
In other words, the good business always expensive. When the dip or pullback happen on the good business, the capital won’t let it dip too much because the capital is smarter now.
If you still not understand, here is an example. When most of capital gambled and traded based on the graph and news, the market value of a good business could below its intrinsic value a lot. However, now, most of the institutional investors are trading based fundamental analysis so they will buy when they find the opportunity no matter big or small.
The simplified process