stock picking – the warren buffet way

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S G Raja Sekharan

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My portfolio performance last year (as of 30th Dec 2012)

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Warren Buffet –The sage of Omaha

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World’s wealthiest – Forbes 2013

Carlos Slim Helu & family –Mexico -$ 73 B – Mobile companiesWilliam Henry Gates –US - $67 B –MicrosoftWarren Buffet – US - $ 53.5 B –Berkshire Hathway

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Warren Buffet –The sage of Omaha• One of the most

successful investors in the world

• Noted for his adherence to “Value Investing”

• Also known for his personal frugality

• Born in 1930, second of three children, father was a stock broker and politician

• Early in school age, he started earning by selling soft drinks and delivering paper

• At 14 years, with his earning, he bought 40 acres of land –which he rented out

• He went to Columbia for graduation - studied under Benjamin Graham –father of Value investing

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Warren Buffet –The sage of Omaha• Benjamin Graham

refused to hire him –saying Stock broking and Wall street was not for him

• Warren Buffet came back –got married and stayed in Omaha with his father’s brokerage

• Benjamin Graham changed his mind and gave him a job in his NY office

• Value investing means seeking stocks selling at extraordinary discounts to the value of it’s underlying assets –defined as “Intrinsic value”

• Buffet went a step beyond Value investing – he looked at the value of a good management team, product’s competitive advantage in marketplace

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Warren Buffet –The sage of Omaha• In 1956, he came back

to Omaha and launched Buffet Associates Ltd

• In 1962, already a 30 year old millionaire –he joined forces with Charlie Munger

• This collaboration eventually resulted in the investment philosophy of Value investing that helped Buffet to get where he is today

• Along they way, they purchased a dying textile mill called Berkshire Hathaway - as a long term investment

• Cash flows from this mill were used to fund other investments – eventually other investments overshadowed the textile business

• In 1985, Buffet shut down the textile business – but continued with the company as a holding company

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Warren Buffet –The sage of Omaha•Buffet picks up stocks in what he believes

are well managed under valued companies•When he purchases any stock – his

intention is to hold the stocks for infinite period of time

•Coke, Amex, Gillette etc are such stocks held by him for many decades

•He also purchases companies outright and let’s their management teams handle their day to day business

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Warren Buffet –The sage of Omaha• He believes that an investor and a

businessperson should look at a company in the same way. The businessperson wants to buy the entire company while an investor wants a part

• The first question any businessperson will ask is, ‘‘What is the cash generating potential of this company?’’

• Over time, there will always be a direct correlation between the value of a company and its cash generating capacity. The investor would benefit by using the same business purchase criteria as the businessperson

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Warren Buffet –his investment philosophy• The basic idea of investing are to look at stocks

as business, use the market’s fluctuations to your advantage, and seek a margin of safety.

• Warren Buffett seeks first to identify an excellent business and then to acquire the firm if the price is right

• Once a good company is identified and purchased at an attractive price, it is held for the long-term until the business loses its attractiveness or until a more attractive alternative investment becomes available.

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Warren Buffet –his investment philosophy• Buffett seeks businesses whose product or service

will be in constant and growing demand. In his view, businesses can be divided into two basic types: ▫Commodity-based firms, selling products where

price is the single most important factor determining purchase.

▫They are characterized with high levels of competition in which the low-cost producer wins because of the freedom to establish prices. Management is key for the long-term success of these types of firms.

▫Buffett avoids commodity-based firms.

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Warren Buffet –his investment philosophy• Buffett seeks businesses whose product or

service will be in constant and growing demand. In his view, businesses can be divided into two basic types: ▫Consumer monopolies, selling products

where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique.

▫Buffet is interested in consumer monopolies

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As per Warren Buffet – there are three types of consumer monopolies•Businesses that make products that wear

out fast or are used up quickly and have brand-name appeal that merchants must carry to attract customers.

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As per Warren Buffet – there are three types of consumer monopolies•Businesses that provide repetitive

consumer services that people and businesses are in constant need of.

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As per Warren Buffet – there are three types of consumer monopolies•Communications firms that provide a repetitive

service that manufacturers must use to persuade the public to buy the manufacturer's products. Advertising agencies, magazine publishers, newspapers, and telecommunications networks are good examples

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Warren Buffet – how does he spot a commodity based business• The firm has low profit margins (net profit

divided by sales)• The firm has low return on equity (earnings

per share divided by book value per share)• Absence of any brand-name loyalty for its

products• The presence of multiple producers• The existence of substantial excess capacity• Profits tend to be erratic• The firm's profitability depends upon

management's ability to optimize the use of tangible assets.

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Warren Buffet – how does he spot a consumer monopoly• The firm has managed to create a product or service that is

somehow unique and difficult to reproduce by competitors due to

Brand name loyalty A particular niche that only a limited number of companies can

enter An unregulated but legal monopoly like patents

• A strong upward trend in earnings• Conservative financing• A consistently high return on shareholder's equity • A high level of retained earnings • Low level of spending needed to maintain current

operations• Profitable use of retained earnings

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Warren Buffet –his investment philosophy•Target successful businesses--those with

expanding intrinsic values; •Value is measured by the ability to generate

earnings and dividends over the years;•Buy at a price that makes economic sense,

defined as earning an annual rate of return of at least 15% for at least five or 10 years (I would opine, in India with Inflation of 10%, we need to target 20% returns).

We will now get into specifics•There are 14 questions that we need to

answer•We will take one corporate example –

Asian Paints and analyze the stock to find out ▫whether is it worth at all? and if yes▫at what price one must buy the Asian

Paints stock

Paint industry in India –an overview•Market size of paints in India is Rs 260 Bn

as of FY 2012 and has grown @ 15% in the past year.

•Unorganized sector consisting of about 2000 units control 35% of the market

•Organized sector has 65% market share –top players in this sector are Asian paints (34% of the 65% organised mkt), Berger Paints(15%), Kansai Nerolac (9%) and Akzo Nobel (8%)

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Paint industry in India –an overview

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  Sales Net Profit Market Cap.Turnover (Rs. cr.)

Asian Paints 8,971.70 1,050.00 44,473.21

Berger Paints 3,024.21 209.8 7,947.62

Kansai Nerolac Paints 2,856.60 292.2 6,332.04

Akzo Nobel 2,231.98 218.83 5,328.84

Top 4 paint companies in India

Paint industry in India –an overview•Low technology and low capital costs help the

unorganized sector – however the reduction in excise duties from 40.5% in 90’s to the current 16% has helped the large units to compete effectively.

•The paint industry is raw material intensive -on an average, raw materials account for 60% of net sales (industry average). In case of small-scale units it forms up to 70% of the net sales.

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Paint industry in India –an overview•Around 300-400 raw materials are

required to manufacture different kinds of paints (pigments, solvents and additives).

•The high number of raw materials and finished goods highlights the working capital intensity of the sector

•Most of the raw materials are petroleum based.

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Paint industry in India –an overview•The products of the paint industry can be

classified into two major segments decorative (architectural) paints and industrial paints

•70% of the paints sold in India are decorative paints – entry barriers here are investments in branding and dealer networks –Asian paints is the leader in this category.

• Industrial paints are used in automotive, marine and other applications –Kansai Nerolac supplying to Maruti makes it the market leader in this market.

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Paint industry in India –an overview•Supply exceeds demand in both the decorative as

well as the industrial paints segments. •Brand, distribution network, working capital

efficiency and technology play a crucial role•The market grows at 1.5 to 2 times the GDP and

with India growing at 8%, the growth is expected to be around 12-15% in the coming years.

•Decorative paints are expected to witness higher growth going forward due to boom in housing sector

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Questions to determine the attractiveness of business – Q1Is it a consumer monopoly or commodity

business –does it have an identifiable durable competitive advantage?

• Consumer monopolies typically have high profit margins because of their unique niche

• Beyond high profit margins, look for companies with operating margins and net profit margins above their industry norms

• Also look for strong earnings and high return on equity will also help to identify consumer monopolies.

• Look at a detailed study of the firm's position in the industry and how it might change over time.

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Questions to determine the attractiveness of business – Q1

Operating profit Mar '12 Mar '11 Mar '10 Mar '09 Mar '08 Mar '07 Mar '06 Mar '05Asian Paints 15.03% 15.98% 17.18% 12.18% 14.24% 12.31% 13.20% 13.05%

Berger Paints 9.50% 9.41% 7.35% 7.38% 8.66% 8.77% 9.18% 8.58%

Net Profit Mar '12 Mar '11 Mar '10 Mar '09 Mar '08 Mar '07 Mar '06 Mar '05Asian Paints 9.93% 10.69% 12.27% 7.30% 9.15% 7.18% 6.91% 6.82%

Berger Paints 5.64% 5.94% 6.08% 4.58% 5.87% 6.34% 6.38% 5.60%

RONW Mar '12 Mar '11 Mar '10 Mar '09 Mar '08 Mar '07 Mar '06 Mar '05Asian Paints 31.68% 34.82% 43.52% 26.58% 32.99% 25.18% 22.21% 21.26%

Berger Paints 22.78% 21.77% 20.18% 21.26% 25.67% 30.36% 31.20% 26.28%

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Questions to determine the attractiveness of business – Q1Is it a consumer monopoly or commodity

business –does it have an identifiable durable competitive advantage?

• Consumer monopolies typically have high profit margins because of their unique niche

• Beyond high profit margins, look for companies with operating margins and net profit margins above their industry norms

• Also look for strong earnings and high return on equity will also help to identify consumer monopolies.

• Look at a detailed study of the firm's position in the industry and how it might change over time.

• YES - Asian Paints has an identifiable durable competitive advantage in the form of it’s brand leadership and it’s distribution network in India

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Questions to determine the attractiveness of business – Q2Do you understand how the product

/service/business model works? • Only invest in industries that you understand –

for example Buffet refused to invest in ecommerce companies during the dot com boom because he did not understand their business

• Yes - Asian Paints – the company buys or makes raw materials, manufactures the paints, distributes it through it’s network and sells it to B2C and B2B customers – profitability comes from efficient operations, volumes and ability to get a premium due to brand positioning .

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Questions to determine the attractiveness of business – Q3What is the chance that the product

/service/business model would be obsolete in the next 20 years?

• Will there be a market for this product 20 years

from now • If there is going to be technological changes

envisaged, then will this company have an upper hand still?

• Yes - Asian paints – The paint product may evolve technically – but paints as a category will survive and Asian paints is expected to have an upper hand due to it’s size and reach.

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Questions to determine the attractiveness of business – Q4Does the company allocate capital

exclusively in the realm of expertise? •Where have been their investments in the

past 5-10 years?•Does the company stick with what it

knows?Yes - Asian Paints has not invested in

unrelated diversification in the past 10 years

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Questions to determine the attractiveness of business – Q5What has been the company’s EPS history

and growth rate• The company must show a consistent growth

in EPS over the past 10 years• Erratic growth and dips in EPS would mostly

make the company unattractive for investment unless there is a clear enough reason visible as to why it happened.

• Yes - Asian Paints has a consistent EPS growth in the past decade and has a EPS CAGR of 26.1%

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Questions to determine the attractiveness of business – Q6Is the company consistently earning

high Return on equity•The company must show a consistently

high ROE over the past 10 years – •ROE = reported net profit /Net worth •Yes – Asian paints has an ROE ranging

from 27.16% to 51.69% with an average ROE of 37.0%

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Questions to determine the attractiveness of business – Q7Is the company consistently earning high

Return on total capital?• The company must show a consistently high Return

on total capital employed over the past 10 years• ROCE = Reported net profit /Total liabilities in BS• Yes -Asian paints has a high ROCE ranging from

18.71% to 43.52% with an average ROE of 28.76%

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Questions to determine the attractiveness of business – Q8Is the company conservatively financed? • Consumer monopolies tend to have strong

cash flows, with little need for long-term debt• Screen for companies with no debt or low

debt – look at the interest coverage ratio –compare with industry peers

• Yes -Asian paints has a debt ranging from Rs. 169 crores to Rs.336 crores and a net profit ranging from Rs. 143 crores to Rs. 1159 crores – the company is conservatively financed

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Questions to determine the attractiveness of business – Q9Has the company been buying back its

shares?• Buffett prefers that firms reinvest their earnings

within the company, provided that profitable opportunities exist. When companies have excess cash flow, Buffett favours shareholder- enhancing manoeuvres such as share buybacks

• This answer if Yes is good - but a NO answer does not disqualify the stock.

• No –Asian paints has not bought back any shares in the past 10 years

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Questions to determine the attractiveness of business – Q10Is the company free to adjust prices to

inflation?•True consumer monopolies are able to

adjust prices to inflation without the risk of losing significant unit sales.

  Mar '13 Mar '12 Mar '11 Mar '10 Mar '09 Mar '08 Mar '07 Mar '06 Mar '05 Mar '04Total Income 11,736.56 10,277.18 8,246.96 7,206.23 5,749.05 4,679.72 3,948.81 3,051.92 2,655.86 2,234.49Reported Net Profit 1159.52 1020.58 881.35 883.91 419.48 428.05 283.49 210.75 181.04 143.81Profitability 9.88% 9.93% 10.69% 12.27% 7.30% 9.15% 7.18% 6.91% 6.82% 6.44%

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Questions to determine the attractiveness of business – Q10Is the company free to adjust prices to

inflation?•True consumer monopolies are able to

adjust prices to inflation without the risk of losing significant unit sales.

•Yes – Profitability ratio of Asian paints is consistently around 8.65% over the past 10 years – that means that inflation does not impact the profits of Asian Paints

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Questions to determine the attractiveness of business – Q11Does company need to constantly reinvest in

capital?• Retained earnings must first go toward

maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better.

• Not really – Asian Paints does not have a large capex for investment in plant and machinery – the main investments are in branding and the SGA as a % of Net sales is around 18%% for the past decade – this is around what any FMCG company would spend.

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Questions to determine the attractiveness of business – Q12What is the initial rate of return (IRR) and

relative value to a Govt bond?• EPS for the year divided by the long-term

government bond interest rate. The resulting figure is the relative value - the price that would result in an initial return equal to the return paid on government bonds.

• We then have to look at the CAGR of the EPS as well.• Asian Paints – assuming a 8% govt bond rate – and

based on the current EPS of 120.88 – the relative value of govt bond would be –Rs 1511

• With the current share price of Rs. 4553 – the Asian Paints share gives a pretax return of 2.65% with the returns growing at 26.1% p.a.

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Questions to determine the attractiveness of business – Q13

What is the projected share value and return on investment using historical earnings growth rate:

• Calculate the CAGR of EPS for the past 10 years• Calculate the average dividend payout ratio

(DPS/EPS) for the past 10 years• Calculate the average PE for the last 10 years• Asian Paints – • CAGR of EPS is 26.10%• Average Dividend payout ratio is 42.58%• Average PE for the last 10 years has been –

23.49

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Questions to determine the attractiveness of business – Q13What is the projected share value and return on

investment using historical earnings growth rate:

• Calculate the EPS for the next 10 years as follows:EPS of year 2 = EPS of year 1 * CAGR of EPS

• Calculate the dividend payout for the next 10 years as follows:Dividend payout for year 2 =EPS for year 2 * average DP ratio

• Calculate the sum of all the dividends paid for the next 10 years

Asian Paints –Historical earnings growth rate method

Historical earnings growth rate method

Year ending EPS DPS2013 120.88 462014 152.43 64.912015 192.23 81.852016 242.40 103.222017 305.68 130.172018 385.47 164.142019 486.10 206.992020 612.99 261.022021 773.00 329.162022 974.78 415.082023 1229.24 523.44Total 2279.99

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Questions to determine the attractiveness of business – Q13What is the projected share value and return

on investment using historical earnings growth rate:

• Projected share price at 10th year = EPS at 10th year * Average PE ratio

• Total estimated gain at the end of 10th year = Projected share price at 10th year + Sum of all dividends for 10 years

• Calculate the CAGR of your investment in 10 years – FOR ASIAN PAINTS THIS IS 23.82%

Asian Paints –Historical earnings growth rate method

Historical earnings growth rate method Year ending EPS DPS EPS after 10 years 1229.24

2013 120.88 46 Sum of Dividend for 10 years 2279.992014 152.43 64.91 Average PE of the stock 23.492015 192.23 81.85 2016 242.40 103.22 Projected share price in 2023 28874.47

2017 305.68 130.17Total gain including

dividends 31154.472018 385.47 164.14 2019 486.10 206.99 Current share price 45532020 612.99 261.02 CAGR of investment 23.82%2021 773.00 329.16

2022 974.78 415.08Target share price for 20% CAGR

6037.94414

2023 1229.24 523.44Total 2279.99

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Questions to determine the attractiveness of business – Q14

What is the projected share value and return on investment using sustainable growth rate:

• Calculate the average PE ratio for the past 10 years -23.49

• Calculate the average ROE for the past 10 years -37%

• Calculate the average dividend payout ratio for the past 10 years – 42.58%

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Questions to determine the attractiveness of business – Q14What is the projected share value and return on

investment using sustainable growth rate:Calculate the Book value of the share for the next 10

years using the formula:• BV for year 2 = BV for year 0 + Retained earnings

for year 1• Retained earnings for year 1 = Projected EPS for

year 1– Projected Dividend Payout for year 1

• Projected EPS for Year 1 = average ROE * BV for Year 0

• Projected dividend payout for year 1 = EPS for year 1* average Dividend payout ratio for past 10 years

Sustainable growth rate modelSustainable growth rate model

Year BVPS EPS DPSRetained earnings

2013 352.8 120.9 46.0 74.92014 427.7 158.2 67.4 90.92015 518.6 191.8 81.7 110.22016 628.7 232.6 99.0 133.6

2017 762.3 282.0 120.1 161.92018 924.2 341.9 145.6 196.32019 1,120.5 414.5 176.5 238.02020 1,358.5 502.6 214.0 288.62021 1,647.1 609.3 259.5 349.9

2022 1,997.0 738.8 314.6 424.22023 2,421.2 895.7 381.4 514.3

Total 1859.81

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Questions to determine the attractiveness of business – Q14What is the projected share value and

return on investment using sustainable growth rate:

• Calculate the EPS for year 10 – Rs. 895.7• Calculate the expected Share Price for year

10 = EPS (FY10)* Average PE = Rs. 21040• To this share price estimate, add the

estimated dividends paid for the next 10 years = Rs 22900

• Calculate the expected CAGR of your investment today – 19.66%

Sustainable growth rate modelSustainable growth rate model

Year BVPS EPS DPSRetained earnings

2013 352.8 120.9 46.0 74.9 EPS in 2021 895.72

2014 427.7 158.2 67.4 90.9 Average PE23.489765

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2015 518.6 191.8 81.7 110.2 Share price in 202121040.229

852016 628.7 232.6 99.0 133.6

2017 762.3 282.0 120.1 161.9

Total gain including dividends 22900.04

2018 924.2 341.9 145.6 196.3 Current share price 45532019 1,120.5 414.5 176.5 238.0 2020 1,358.5 502.6 214.0 288.6 CAGR of investment 19.66%2021 1,647.1 609.3 259.5 349.9

2022 1,997.0 738.8 314.6 424.2

Target share price for 20% CAGR

2023 2,421.2 895.7 381.4 514.3 Total 1859.81

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At what price should one buy Asian paints stocks

Based on Historical earnings method:Total gain in 10 years – Rs 31554Based on sustainable earnings

method:Total gain in 10 years – Rs 22900Taking the conservative of the two

estimates – we will take the sustainable earnings method in this case.

For a 20% CAGR, the current price for buying needs to be Rs 4438.

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Agro Tech foods

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Bajaj Auto

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BHEL

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Colgate Palmolive

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CRISIL

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Dabur India

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Gruh Finance

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HDFC Bank

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L&T

68

Jubilant Foodworks

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Maruti Suzuki

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Page Industries

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Shriram Transport Finance

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TCS

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TTK Prestige

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Bharti Airtel

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Cox and Kings

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Noida Toll bridge

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My view on equity in 2013/14

•Markets expected to be volatile due to elections in 2014

•Post elections, there will be stability and optimism as all parties have similar economic agenda

•Pick select equity after fundamental analysis during 2013 – there are opportunities in volatile markets

I have a private mailing list where I share my buy and sell activities in stock markets. You can write to me and be part of this list – remember, the rewards are yours and the risks are yours

Through this book , I am sharing ideas on how to good ROI by investing well in Equity, MF’s, Real estate , Gold ,Debt and Insurance

You can reach me through my mail id:

rajasekharan.sg@gmail.com

You can also subscribe to my wealth management blog:

http://mbaclassdiscussions.blogspot.in/

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100% of book sale 100% of book sale proceeds here go proceeds here go

towards towards education for education for

Kaveri – a very Kaveri – a very intelligent girl intelligent girl

from tribal from tribal background who background who needs funds for needs funds for her educationher education

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