Tuesday, August 30, 2011

Value Investing rules for small investors

The first set of value investing rules for small investors is as follows:
1. Concentrates in the purchase of shares of existing companies is well established in the market.
2. Invest in companies operating in sectors which are growing very fast.
3. Buy companies in difficulty to get shares at undervalued prices
4. Buy companies with a sustainable competitive advantage
5. Bet with strength (large funds to be invested) when the odds are strongly in your favor (like if you see an undervalued shares).

Let’s see in detail, starting from the analysis of competitive advantage, one of the historic strengths of value investing and, in particular, approach to investments of Warren Buffett.

Buy companies with a sustainable competitive advantage

“In our investments the companies that we believe are virtually certain to possess enormous competitive strength ten or even twenty years are the only companies we prefer”, Warren Buffett writes in his letter to investors in 1996.

Why? The reason is simple. This is a feature that ensures excellent performance in the long run. Good companies with good ‘moats’ (competitive advantages that protect against competition) generate high returns on investment.

A look at financial statements can therefore help to identify companies with competitive advantages. Year after year, the return on investment is significantly higher than the average, it is logical to infer that the company has particular strength of the points that make it difficult to be attacked.

In the Magic Formula of Joel Greenblatt (Earning Yield), of which I wrote in detail in another post , will highlight how you can identify quality companies which are available at undervalued prices. The concept is called “return on capital employed” – defined as EBIT / net working capital + net fixed assets – is one of the two parameters on where the formula is based).

Of course, once noted that a competitive advantage exists, the question is whether and to what extent it will be durable .

There are five competitive forces that together determine the intensity of competition and, consequently, the profitability of an industry:

(1) the threat of entry of new competitors,
(2) threat of substitute products or services,
(3) the bargaining power of suppliers,
(4) the bargaining power of customers,
(5) the degree of rivalry among existing competitors.

Cite among companies that have managed to build around him the large “moats” names like American Express, Coca-Cola, BMW or Harley Davidson, or, more recently, eBay, Google and Microsoft. Among those practically free of “gap” were other means, “notables” as invalid, Delta, Gateway or General Motors.

The interesting observation is that even for companies like Delta, Gateway or General Motors, there was a time when enjoyed significant competitive advantages that made them great. But in the nature of capitalist competition to proceed there is a gradual destruction of these “moats.”

When calculating the intrinsic value of a company, getmoneyrich recommended to use not more than 10 years of cash flow , and never exceed 15 times the multiple of cash flow to calculate the final value . The forces of “creative destruction” are impressive, and no competitive position is likely to continue indefinitely.

Here is what Buffett wrote in the letter to investors in 1999:
“Several of the companies in which we have substantial investments have reported disappointing results last year. However, we believe that these companies have significant competitive advantages that will last over time. “

“This explains, among other things, because we do not play in the portfolio securities of technology companies. Even if we share this point of view with all that our world will be transformed by their products and services” Warren Buffett

“Our problem – we cannot seem to understand is that what these companies of technological field possess that gives them its competitive advantage . ” [...]

Warren Buffett prefers to operate well within his circle of competence. Predicting long-term prospects of companies operating in rapidly changing industries goes far beyond our perimeter (like IT companies)

“An industry that is changing rapidly can offer the possibility of huge gains but this is not the security we seek.”

“I want to emphasize that, as citizens , Charlie and I are in favor of the change : original ideas, new products, innovative processes and things like improving the living standards of our country, and this of course is good. ”

“As investors , however, our reaction to an industry in turmoil is similar to the attitude with which we do ‘s space exploration : we applaud the company but prefer to avoid embarking on a trip. ”

When it comes to form the belief that a share has a high probability of beating the market over the medium to long-term bet there hard. Typically, about 80% of the assets of the fund managed by him have been concentrated in only 5 titles, his five best ideas.
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