The Joys of Compounding by Gautam Baid
Intelligent Investing is all about understanding Intrinsic value
Warren Buffett has described intrinsic value as private owner value, the price that an informed buyer would pay for the entire business and its future stream of cash.
The earnings used for valuation purposes by investors are the owner’s earnings.
Net income and EPS are figures reported according to accounting principles, but the actual cash that the business owner can withdraw differs. Owner earnings tell us how much money comes into the business owner’s pockets, which is supposed to be actual, spendable cash, not inventory and receivables.
This is why Buffett refers to it as "owner earnings."
The longer the competitive advantage period (CAP), the more likely a business is worth a lot more than what the market thinks. “Durability” of the moat is the critical factor.
Ten dollars of earnings from a capital-light business like Moody’s, with its low reinvestment requirements, is worth a lot more than the exact earnings figure from a capital-intensive industry like General Dynamics, so investors should capitalize each of them differently.
Investors have to look at each business’s earning power, along with the company’s prospects, to decide how much they are willing to pay to acquire that business’s future cash flows.
The traditional “value investor” mentality of buying cheap securities, waiting for them to bounce back to “intrinsic value,” selling and moving onto the next opportunity, is flawed.
In today’s world of instant information and fast-paced innovation, cheap securities increasingly appear to be value traps; often, they are companies ailing from technological disruption and long-term decline. This rapid recycling of capital also creates an enormous drag on our after-tax returns. In addition, by focusing on these opportunities, we incur substantial opportunity costs by not concentrating instead on the tremendous opportunities created by the exceptional innovation.
Another Important thing which the author focuses on is switching from a high P/E stock to one with a low P/E which proves to be a mistake.
Value traps are abundant and all pervasive. Everything trades at the level it does for a reason. High quality tends to trade at expensive valuation and junk or poor quality is frequently available at cheap valuation.
It took him many years to learn this big market lesson: expensive is expensive for a reason and cheap is cheap for a reason. In the stock market, prices usually move first, and the reported fundamentals follow.
(For instance, debt issued by listed companies, stock price behavior usually turns out to be a more accurate barometer for gauging the probability than ratings given by the credit rating agencies.)
A plummeting stock price (in an otherwise steady market) often turns out to be an accurate harbinger of deteriorating fundamentals for a company. Think about this before you jump in to buy.
Avoid investing in melting ice cubes. What appears to be cheap or relatively inexpensive can continue becoming cheaper if industry headwinds intensify. An irrational fall in price makes a stock cheaper. A rational fall in price makes a stock more expensive. Many of the high dividend-yield stocks in expensive markets eventually turn out to be value traps and destroy wealth.
When you see a deep value stock suddenly break down on high volumes with no visible explanation, take notice. You are likely observing a value trap. Value traps are businesses that look cheap but actually are expensive. This could happen for a variety of reasons:
Cyclicality of earnings
A low P/E stock may look cheap because the business is enjoying cyclically peak earnings, but the normalized P/E may not really be low if adjusted for cyclicality.
A taxi company may look cheap based on past earning power, but that may have existed only until Uber arrived.
Bad capital allocation by the management
The market may correctly be punishing a business by assigning a low multiple to its earnings because the managers keep burning cash in bad projects and there is no prospect of such misallocation to be stopped.
A business run by a crook may appear to be quite cheap relative to the large amount of cash reported on its books, until that cash is completely siphoned off. Give zero valuation to the cash held in the books of a business being run for social purposes or owned by shady promoters. Gains in intrinsic value often are not reflected in realized returns for investors because insiders channel the gains to themselves.
Avoid partnering with such forms of management even if it comes at the cost of missing an opportunity. The notional loss from not capitalizing on an opportunity can be made up any time, but the eventual realized loss from partnering with a crook is permanent and irrecoverable.