Pat Dorsey - 5 Rules for Successful Stock Investing summary

When looking at PE ratio, make sure that you look at the historical PE and make sure that you don’t buy it at the high. If you do buy it at the high, you have to be confident of the company’s outlook. More often than not, it is overestimating growth prospects. DISCIPLINE + CONSERVATION in figuring out the prices. When should you sell? 1) 2) 3) 4) 5)

Did you make a mistake Have the fundamentals deteriorated? Have the stock risen too far above its intrinsic value? Is there something you can do better with the money? Do you have too much money in one stock? – Don’t make sense to have too much egg in one basket

Chapter 2 7 mistakes: 1. Swinging for the fence 2. Believing that it’s different this time: not knowing market history is a major handicap 3. Falling in love with products 4. Panicking when the market is down 5. Trying to time the market: Stock market returns are highly skewed- bulk of the returns (positive or negative) from any given year comes from relatively few days in that year. This means that the risk of not being in the market is high for anyone looking to build wealth over a long period of time. 6. Ignoring valuation: the reason you should buy a stock is that you think the business is worth more than it’s selling for- not because you think a greater fool will pay more for it down the road. Buying the stock based on the expectation of positive news flow or strong relative strength is asking for trouble. 7. Relying on earnings for the whole story: cash flow not earnings. This statement of cash flows can yield a ton of insight into the true health of a business, and you can spot a lot of blowups before they happen by simply watching the trend of operating cash flow relative to earnings. Watch out operating cash flows stagnate or shrink even as earnings grow, it’s likely that something is rotten. Chapter 3 The bigger the profit, the stronger the competition. To evaluate moat: 1) evaluate the firm’s historical profitability. Has the firm been able to generate a solid return on its assets and on shareholders’ equity? This

is the true litmus test of whether a firm has built an economic moat around itself. a) Does the firm generate FCF? How much? Divide FCF by sales (revenues), which tell you what proportion of each dollar in revenue the firm is able to convert into excess profits. If a firm’s FCF as a percentage of sales is around 5 percent or better, you’ve found a cash machine - as of mid-2003, only one-half of the S&P 500 pass this test. Strong FCF is an excellent sign that a firm has an economic moat. b) What are the firm’s net margins? ROE? (Chapter 6) c) ROA: 6-7% d) ROIC and estimating a weighted average cost of capital (WACC) 2) If the firm has solid returns on capital and consistent profitablility, assess the sources of the firm’s profits. Why is the company able to keep competitors at bay? What keeps competitors from stealing its profits? a) We need to determine why a firm has done such a great job of holding on its profits and keeping the competition at arm length. The strategy pursued at the company level is even more important. Research shows that a firm’s strategy is roughly twice as important as a firm’s industry when it’s trying to build an economic moat. b) Key is never stop asking, “why?” why aren’t competitors stealing the firm’s customers? Why cant a competitor charge a lower price for a similar product or service? Why do customers accept annual price increase? c) Look at it from the customer’s perspective. 5 ways firm can build sustainable competitive advantage: 1. Create real product differentiation through superior technology or features 2. Creating perceived product differentiation through a trusted brand or reputation: not enough to look at whether consumers trust the product or have emotional connection to the brand. The brand has to justify the cost of creating it by actually making money for the firm and sustaining a powerful brand usually requires a lot of expensive advertising. 3. Driving costs down and offering a similar product or service at a lower price: Low cost works well in commodity industries. Identify the sources of these cost savings. Create cost advantages by either inventing a better process or achieving a larger scale. Look at business model. 4. Locking in customers by creating high switching costs 5. Locking out competitors by creating high barriers to entry or high barriers to success: regulatory exclusivity

3) Estimate how long a firm will be able to hold off competitors, which is the company’s competitive advantage period: economic moat – width and depth 4) Analyse the industry’s competitive structure. How do firms in this industry compete with one another? Is it an attractive industry with many profitable forms or a hypercompetitive one in which participants struggle just to stay afloat. Analysing a company: Growth: sources and sustainability, sales growth drives earnings growth. Profit growth can outpace sales growth for a while if a company can cut costs or fiddle with the financial statements. So look at sales growth. To grow sales: Sell more products, raise price, sell new goods or services, acquisition( management can use the fog created by constant acquisitions to artificially juice results, and this financial tinkering can take a long time to come to light because its buried in the financial rejiggering and true growth is impossible to figure out because cant determine organic growth) Profitability: What kind of a return does the company generate on the capital it invests. Look at revenue. Instead of profit. Look at RRP. Financial health: How solid is the firm’s financial footing Risks/bear case: Look at full story Management: Who’s running the show ROA: Asset turnover, sales divided by assets Financial leverage: Assets/shareholders’ equity ROE: net margin x asset turnover x financial leverage 2 caveats: 1) Banks always have enormous financial leverage ratios, so don’t be scared off by a leverage ratio that looks high relative to a nonbank. In addition, because banks’ leverage is always so high, you want to raise the bar for financial firms-so look for consistent ROEs above 12% or so. 2) Concerns firm with ROEs that look too good to be true, >40% is a no no. Firms that have been recently spun off from parent firms, companies that have bought back many of their shares, and co that have taken massive charges often have very skewed ROEs because their equity base is depressed. FCF: any firm that’s able to convert more than 5% of sales to FCF-just divide FCF by sales to get this percentage- is doing a solid job at generating excess cash.

Putting ROE and FCF together: One good way to think about the returns a company is generating is to use the profitability matrix, which looks at a company’s ROE relative to the amount of FCF it is generating. High ROE+ High FCF ROIC: puts debt and equity financing on an equal footing: removes the debt related distortion that can make highly leveraged companies look very profitable when using ROE. ROIC uses operating profits after taxes, but before interest expenses. Again, the goal is to remove any effects caused by a company’s financing decisions-does it use debt or equity?-so that we can focus as closely as possible on the profitability of the core business. ROIC= net profit after taxes/ invested capital Invested capital= total assets-non interest bearing current liabilities (usually account payable, accrued liabilities and other current liabilities)-excess cash (and maybe goodwill if it is a large portion) Financial leverage of 4,5 is risky. For every $ of equity, there is $4/5 worth of assets. Means borrow $3/4. After assessing growth, profitability and financial health, your next task is to look at the bear case for the stock you’re analysing. List the potential negatives so that you will have the confidence to hang on to the stock during a temporary rough patch as well as the savvy to know when the rough patch might really be a serious turn for the worse. Look at the customers of the business as well. Chapter 7: Management – 3 parts: compensation, character and operations. Compensation: bulk of information is found in proxy statement. First look at how much management pay itself. See if bonus driven, raw level of cash compensation to see if it’s reasonable. $8m cash bonus is silly no matter what. Also, look at competing firms to see what their CEOs are paid. Other red flags Were executives given ‘loans’ that were subsequently forgiven? (loans of this sort are usually disclosed in the ‘other compensation’ column of the executive compensation table in the footnotes.) Do executives get perks paid for by the company that they should really be paying for themselves? Does management hog most of the stock options granted in a given year, or do rank and file employees share in the wealth? Generally, firms with more

equitable distribution schemes perform better over the long run. Most firms break out the percentage of options granted to executives relative to the total granted in the proxy statement. Does management use stock options excessively? Even if they are distributed beyond the executive suite, giving out too many options dilutes existing shareholders’ equity. If a company gives out more than 1 or 2 percent of the outstanding shares each year, they are giving away too much. Better if firm issues restricted stock instead of options. Restricted stock has to be counted as an expense on the income statement (options don’t, as of this writing), and restricted stock also forces the recipient to participate on the downside if the stock falls. If a founder or large owner is still involved in the company, does he or she also get a big stock option grant each year? Do executives have some skin in the game? Do they have substantial holdings of company stock or do they tend to sell shares right after they exercise options? Large unexercised option positions are cold comfort. You can find this information in the footnotes of the proxy. Companies indicate executives percentage ownership including options prominently in a table labeled ‘security ownership of certain beneficial owners’, but they declare only how many actual shares are owned in the footnotes. Does management use its position to enrich friends and relatives? Look for a section called ‘related-party transactions’. Does it pay money to family members’ business. Is the board of directors stacked with management’s family members or former managers? Is management candid about its mistake? How promotional is management? Care about stock price or company? Can CEO retain high-quality talent? How often do officers turn over? Does management make tough decisions that hurt results but give a more honest picture of the company? Management teams that use restricted stock grants instead of options-because the former has to be expensed, while the latter doesn’t-or who expense rather than capitalize items such as research and development or software costs are the kind of folks who are more interested in running the business than playing number games. Those are the people that you want. Running the business Dig out past M&A activity. Look at the share count over a long period of time. If the number of shares outstanding has increased substantially because of

aggressive operations programs or frequent equity issuance, the firm is essentially giving away part of your stake without asking you. Follow-through: does it implement the plan? Candor Self confidence: do something different from their peers or from conventional opinion. Flexibility: has management made decisions that will give the firm flexibility in the future? Like not taking on too much debt and controlling fixed expenses (even in good years), as well as issuing equity when the stock is high. Attaching call options to debt, retiring high rate debt when the opportunity presents itself, and buy back stock at low prices. 6 red flags 1) Declining cash flow: if cash from operations decline even as net income keeps marching upwards or if cash from operations increase much more slowly than net income. AR increased to a large percentage of sales. Inventories increase 2) Serial chargers: frequent chargers are an open invitation to accounting hanky panky because forms can bury bad decisions in a single restructuring charge. Poor decisions that might need to be paid for in future quarters all get rolled into a single one-time charge in the current quarter, which improves future result. 3) Serial acquirers: acquisitive firms don’t spend as much time checking out their targets as they should. 4) CFO or auditors leave the company: If a company fires its auditors after some potentially damaging accounting issue has come to light, watch out. 5) The bills aren’t being paid: One way to pump up its growth rate is to loosen customers’ credit terms, which induces them to buy more products or services. If they don’t get paid, it will come back to haunt them in the form of a nasty write-down or charge against earnings. Track how A/R are increasing relative to sales. On the credit front, watch the ‘allowance for doubtful accounts’. If the amount doesn’t move up in sync with A/R, the company may be artificially boosting its results by being overly optimistic about how many of its new customers will pay its bill. 6) Changes in credit terms and account receivable: Check the company’s 10Q filing for any mentions of changes in credit terms for customers, as well as for any explanation by management as to why A/R has jumped. ( Look in the management’s discussion and analysis section for the latter and in the accounting footnotes for the former.) 7) Gains from investments: an honest company breaks out these sales, however, and reports them below the ‘operating income’ line on its income statement. The problem arises when companies try to boost their operating results-performance of their core business-by shoehorning investment income into other parts of their financial statements. Finally,

companies can hide investment gains in their expense accounts by using them to reduce operating expenses, which makes the firm look more efficient than it really is. 8) Pension pitfalls: If assets in the pension plan don’t increase quickly enough, the firm has to divert profits to prop up the pension. To fund pension payments to future retirees, companies shovel money into pension plans that then are invested in stocks, bonds, real estate, and so forth. If a company winds up with fewer pension assets than pension liabilities, it has an underfunded plan, and if the company has more than enough pension assets to meet its projected obligations to retirees, it has an overfunded plan. To see whether the company has an over-or underfunded pension plan, go to the footnotes of a 10-K filling and look for the note labeled ‘pension and other postretirement benefits’, ‘employee retirement benefits’, or some variation. Then look at the line labeled ‘projected benefit obligation.’ This is the estimated amount the company will owe to employees after they retire. Second key number is ‘fair value of plan assets at the end of year’. If the benefit obligation exceeds the plan assets, the company has an underfunded pension plan and is likely to have shovel in more money in future, reducing profits. Pension padding: When stocks and bonds do really well, pension plans go gangbusters. And if those annual returns exceed the annual pension costs, the excess can be profits. Flowing gains from an overfunded pension plan through the income statement is a perfectly legal practice that pumped up earnings at GE. You should subtract it from net income when trying to figure out just how profitable a company really is. To find out how much profits decreased because of pension costs or increased because of pension gains, go to the line in the pension footnote labeled either ‘net pension/postretirement expense’, ‘net pension credit/loss’. Companies usually break out the contribution of pension costs to profits for the trailing three years; therefore, you can see not only the absolute level of pension profit or loss, but also the trend. Won’t see these numbers in the income statement. 9) Vanishing cash flow: you can’t count on cash flow generated by employees exercising options. The amount is labeled ‘tax benefits from employee stock plan’ or ‘tax benefits of stock options exercised’ on the statement of cash flows. When employees exercise their stock options, the amount of cash taxes their employer has to pay declines. If the stock price takes a tumble, many people’s options will be worthless and, consequently, fewer options will be exercised. Fewer options are now exercised, the company’s tax deduction gets smaller, and it has to pay more taxes than before, which means lower cash flow. If you are analyzing a company with great cash flow that also has a high flying stock, check to see how much of that cash flow growth is coming from optionsrelated tax benefits.

10) Overstuffed Warehouses When inventories rise faster than sales, there is likely to be trouble on the horizon. Sometimes buildup is just temporary as a company prepares for a new product launch, usually exception. 11) Change is bad: another way firm can make themselves look better is by changing any one of a number of assumptions in their financial statements. Look skeptically on any optional change that improve results. One item that can be altered is depreciation expense (see if extend depreciation period). Firms can also change their allowance for doubtful accounts. If it doesn’t increase at the same rate as accounts receivable, a firm is essentially saying that its new customers are much more creditworthy than the previous ones-which is pretty much unlikely. If the allowance declines as AR rises, the company is stretching the truth even further. Current results are overstated. Firms can also change things as basic as how expenses are recorded and when revenue is recognized. 12) To expense or not to expense Company can fiddle with their costs by capitalizing them. Any time you see expenses being capitalized, ask some hard questions about just how long that ‘asset’ will generate an economic benefit. Valuation- The basic Stock market returns come from two key components: investment returns and speculative returns. Investment returns is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas speculative return comes from the impact of changes in the PE ratio. Using Price Multiples wisely Price to sales: current price of the stock divided by sales per share. Price-to-sales is used for spotting recovery situations or for double checking that a company's growth has not become overvalued. It comes in handy when a company begins to suffer losses and, as a result, has no earnings (and no PE) with which investors can assess the shares. Retailers, which typically have very low net margins, tend to have very low P/S ratios. Price to book: stock market value vs equity value. For service firms, P/B has little meaning. Also can lead you astray for a manufacturing firm such as 3M, which derives value from its brand name and innovative products. Another item to be wary of is goodwill, which can inflate book value to the point that even the most expensive firm looks like a value. Be highly skeptical of firms for which goodwill makes up a sizable portion of their book value, The P/B may be low, but the bulk of the B could disappear in a hurry if the firm declares the goodwill as ‘impaired’(firm admits that it grossly overpaid for a past acquisition) and writes down its value. PB is also tied to ROE in the same way PS is tied to net margin.

Higher ROE will have a higher P/B ratio. P/B is very good for valuing financial services firms because most financial firms have considerable liquid assets on their balance sheets. Financial firms trading below book value (