Wednesday, August 31, 2011

Identify Exceptional Companies for Stock Investment

When it comes to Investment, Warren Buffett stands tall than any of his compatriots. I was reading the book by Robert G. Hagstrom called “The Warren Buffett Way” and I would like to keep a note of important things I have read in this book:

Philip Fisher was another great investor and a guide to Warren Buffett. The concept of Fisher was slightly different from Benjamin Graham.

He beleived that “he would rather own a few outstanding companies than a large number of average businesses. Generally, his portfolios included fewer than ten companies, and often three to four companies represented 75 percent of his entire equity portfolio.”

He beleived that the stock prices are very unpredictable. He wanted to devise and fool proof system which enabled him to evaluate companies based on their fundamentals rather on their market valuation of stocks. He decided that the performance of a compnay in the last few financial years game a great insight on the fundamentals of a compnay. A compnay with strong fundamentals must be kept in the portfolio irrespective of what prices its stocks. In long run, good companies will grow and will benefit the investors. But the question was how to evaluate companies fundamentals? He had a four formulation point :
  1. The sale of the company must have grown at rates higher industrial average
  2. The profit of the company must have grown at rates compareable to its sale (profit margins)
  3. The accounting and financial statements of company must be explicit
  4. The company shall not grow (finance its growth) just by floating more and more shares.
The sale and profit margin principles of Fisher are known to one and all, but his balance two points needs a bit for explanation. When he said that the accounting and financial statements of the compnay must be good, he was trying to analyze whether the compnay is tracking its expenditures and cost or not. A compnay can never sustain their profits if they do not check and control their costs. To control their costs, they must know where they are spending.

Financial statements like balance sheets, cash flow statement and profit and loss accounts are a great tool to control the expenditures of the company.
Lastly, all companies need to grow to maintain their dominance. To grow the companies often needs expansion and modernization projects. To execute these projects companies needs capital. Companies that are majorly dependent on stocks to raise their capital are not good for investors.

Lets take an example, suppose the number of outstanding shares for a compnay X is 100 and their level of PAT is (Net Earning) $100. Ideally all companies shall disburse their net earnings to their share holders, hence if X wants to distribute $100 equally among 100 shares, then earning per share (EPS) will be $1. Now, if company floats and additional 100 shares to finance its projects and in the year end makes net earning of $150. What does it mean to its share holders, earning per share (EPS) will be $150/200 = $0.75. If earning per share has fallen from $1 to $0.75 then it means a loss to its shareholders as compared to their last year earnings.
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