Why improving your skills may lead to more luck

If you are a golfer you know that you don’t always the skills to hit the ball perfectly.

Sometimes you miss the ball ever so slightly and the results are horrible.

But sometimes the reverse is true – you miss the shot, but your drive still turns out all right and somehow it seems as though the better you get at the game, the more it happens.

How can that be?

Of course, if you improve your skills, the better at the game you will get. That’s a given.

So then when you hit the ball badly, you have practiced enough on your swing not to make a complete mess out of the shot.

That’s all very good, but what has that got to do with investing?

Quite a lot it turns out.

If you are getting into the habit of analyzing your stocks you will eventually acquire skills.

Those skills are crucial when it comes to determine if a certain stock provides good value or not.

When you decide to either sell or buy new stock of a particular company, you will realize that you are getting better at it over time.

What in the past may may have seemed as good decision will with improved skills rank lower and vice versa.

Conclusion:

The better you get at something the luckier you will get.

 

 

 

 

Stop wasting time

It is a dream of many investors is to hit a “ten bagger”.

A “ten bagger” is where you are making more than ten times your initial investment when exiting the investment.

Of course, it’s nice when it happens, but it’s important to remember that not all stocks have that potential.

During the course of your life you will be lucky to get 5 or 10 of those, maximum.

In most other cases stocks will be so overvalued that it will be virtually impossible to find a stock that grows as much.

The question then becomes what do you do when you can’t find any good investment opportunities.

To answer that question we first need to recognize that there are  many different investment strategies. You can for example look at the charts, at growth companies or you can buy them all in an index-fund.

But the one that I favor is one where you are buying great value at a decent price (and not the other way around).

That is the reason why it pays off in the long run to wait for the opportunities to arise. They always do.

So you may think that you are wasting your time when you are not buying, but it is not true. What you are really doing is that you are waiting for the price to come down to a more favorable point.

 

 

 

 

My top 10 financial metrics

No matter how long you’ve been investing, there will inevitably come a time when you ask yourself if there’s a financial metric that is better than the others. What financial metrics can do is to help you to put a number on the value of a company.

So the question is, how do you find the best financial metric for your taste? If it’s already popular by other investors, you should also be able to use them, right?

Here are my 10 preferred financial metrics (listen in no particular order):

1. The Price to earnings (P/E) ratio. This is a classic when it comes to valuation. What you do is that you take the current market price of the stock and divide by the earnings per share. What you end up with is a number that tells you how much you are paying for the stock. The lower the number the cheaper the stock.
2. The Price to average earnings ratio. This is an alternative to the normal P/E ratio. What you do is that you take the current market price of the stock and then you divide the average over a given number of earnings. What I prefer to do is to look at the three years, but at least in theory, any number would do.
3. The Price to trailing earnings ratio. This is when you follow the stock in detail and know the exact each quarter. Then you can calculate a trailing P/E ratio even in, let’s say, the second, third and fourth quarter without estimates.
4. The Price to forward earnings ratio. This metric is similar to the one above but the difference is that instead of calculating the full four quarters earnings, you estimate next quarters’ earnings. I somehow prefer this metric to the one above.
5. The CPI-adjusted Price to earnings ratio. This deep value ratio can come in handy if you have a period of intense inflation that distorts the real value of the average. What we are doing here is that we are adjusting every earning with the CPI. What that gives us is a number that is adjusted for inflation. The problem with this kind of metric is that the business is likely to change during the ten years that we are looking at. I therefore prefer to only look at five years back.
6. The Price to book ratio. This is where you take the current price of your stock of choice and you divide with the book value. Now, the book value is calculated by taking the company’s total assets and subtracting its total liabilities and also the intangible assets that the company might have. If you are an observant reader, you will recognize that total assets minus total liabilities is what is called Shareholders’ equity.
7. The Free cash flow yield. The free cash flow is an important metric for calculating how much comes in and out of the company in given year. The metric is defined by taking the operational cash flow and then subtracting the costs that company infers for maintaining its asset base. The free cash flow yield then comes from taking the price of the stock and then divide by the free cash flow per share
8. Current assets to current liabilities. This metric tells you how much more current liabilities that there are in the company. The numbers for this can be either be found in the balance sheet of the company’s quarterly or annual report.
9. Debt to equity. This is where you compare the total liabilities that the company has to its equity. The number tells you something about if the debt load is high or low. The numbers for this can also be found in the balance sheets of the quarterly or the annual reports.
10. Return on equity. This profitability metric tells you how much profit the company makes in relation to the equity. The number tells you how good the company is at reinvest its capital. Personally, I prefer to see a ROE above 17 per cent in order to be happy.

Conclusion:

Today I’ve been talking about my favourite financial metrics. Have I missed any? Leave your comments below!

If you would like to learn more about this topic, you can check out my Guide to value investing for beginners.

Pepsico, Inc.

Fundamental analysis of Pepsico, July 10, 2017

Update, September 12, 2017

Pepsico is valued at 26.5 times 2016 earnings which is expensive. If we assume that the company will be making $4.50 this year, which is in line with what they’ve been earning so far in 2017, the P/E ratio comes in at 25.7 which is still very expensive. The P/E over the past three years’ earnings is 28.2.

The Free cash flow yield comes in at 4.4 per cent which qualifies the stock in the “watch” category.

The only reason why you would want to own such a stock is the dividend of $3.06 per share (2.6 per cent yield). In an environment where you are getting 2.17% on a 10-year note this may be interesting for some people. However, as it stands the stock is too expensive for me.

 

 

Update:

The day after publishing this we figured out that the company presented their earnings.

The earnings came in better than anticipated and we can now make estimated guesses for next year’s earnings.

We think they will come in around $4.50 per share which equates to a forward P/E of 25.3.

That is still far too expensive for my taste.

Yesterday interestingly the share went down 0.5 per cent to $113.74.

Valuation:

At $115 and a trailing P/E value of 26.5 the PepsiCo share is expensive. Over a period of three years, the P/E ratio is even higher at 28.2. Because of their high degree of intangible assets the Book value is negative so a measure like Price to book does not make sense.

 

Balance sheet:

PepsiCo has a Working capital of $6 billion but the Working capital to debt is low at only 0.1. The Debt to equity ratio is extraordinarily high at 5.6.

In all, PepsiCo’s balance sheet could look better.

 

Free cash flow and dividend:

The company has a Free cash flow of $7.4 billion which equates to $5 per share. Of this they both buy back outstanding shares and pay a good dividend of $2.96 (2.6 per cent). The earnings look stable.

PepsiCo has been paying out uninterrupted and increasing dividends for more than 25 consecutive years.

 

Conclusion:

At 26.5 times trailing earnings PepsiCo is too expensive for my taste. At these prices I would call it a SELL.

 

If you would like to learn more about fundamental analysis you can do that here.

Discipline is having the strength to say no

What does it take to say no?

As an investor, you are more likely than not to have been in a situation like this:

You are listening to a presentation of a company that you are interested in.

The CEO is making his pitch and it is tempting. The business model sounds fool proof and you are on the verge of buying equity in the company.

But is it a good idea to buy just when you’ve listened to a presentation with a CEO?

Of course it is not. As always, you owe yourself some due diligence before making any investment decisions.

That is why I advice you to wait a week before buying if you’re tempted. If by then, it’s still a good proposition then buy. Otherwise you say no.

Why is it so difficult to say no?

As famous investor Benjamin Graham once said:

Every investment decision should be taken with safety of principal and a good rate of return in mind.

In the example above, the safety of principal is to say the least dubious.

There is simply no guarantee that you will be able to get your money back if you invest in an “interesting startup”. Additionally, the rate of return will almost certainly be non-existent in a speculation like this.

You don’t want to go there.

 

What you should do instead

You need to take an ice cold look at the prospect and not letting your feelings run high.

You need to carefully analyze the investment proposition looking at different key numbers from both the company in question and competing companies.

One thing that is extremely important is the earnings where a good investment is characterized by solid earnings. It makes no sense to invest in a company that is loss making.

If you after careful analysis come up with a negative outlook for the company, then you owe yourself to say no.

 

To say no is not a sign of weakness – it’s a sign of strength.

The more you look at different companies, the more experience you will acquire.

What that means is that you will look at many investment propositions before finally acting on one or two.

You will then be more secure in your decisions and not waste any money on useless propositions.

 

 

Don’t compare yourself to others

In order to be a successful investor, you shouldn’t compare yourself to others.

It is difficult being an investor. Sometimes the price of your stocks rise for no apparent reason and sometimes they fall seemingly without any cause.

Then it is easy to either buy or sell just to make a few more dollars short-term, but that is a not how you should think about the problem.

The correct way is to make as few investment decisions as possible. Warren Buffet has famously said that “you would be better off if you limited yourself to, let’s say, 20 investment decisions in your lifetime”.

If the trading was limited, you would have to justify to yourself why and at what price you want to execute this particular trade.

Hopefully you would then skip a few of the bad deals that you are bound to do in affect.

That inevitably means that you will miss out on some opportunities.

But that is not a bad thing – it’s a good thing.

When you are seeing a stock rise, and you’ve carefully looked at the financials of that particular stock, it’s very satisfying finally being proven right.

The downsides of trading

Now you may be thinking “That sounds all very good, but I don’t want to keep my stock if it goes to zero.”

Again, that is not the way you want to think about your investments.

If the value of your stocks are falling it means that they have become cheaper and you can buy more.

Depending on the quality of your investment decisions, the dividend that you are receiving should be safe if you’ve bought good stocks.

That means that you will not miss out on the compound interest that you will earn by simply keeping your stock.

If you in any way are concerned about the compound interest please keep your stock.

Conclusion:

In today’s post we have been looking at the many pitfalls when it comes to comparing your portfolio to others.

 

Concentrating on a few companies is a great way to learn investing

You want to start investing, but you have no idea of where to start. Where do you begin to learn investing?

In the beginning it can seem overwhelming.

Should you invest in bonds, stocks or a combination of both?

If you begin with equities should you start with bigger companies or smaller?

How do you pick the stocks in which you want to invest in the first place?

The default option is to invest in an index fund – I’ve been talking about that solution before.

There is a small problem with that solution though and that is that it is boring.

Therefore I suggest that you choose three to five stocks that are publicly traded and you begin to follow them.

The good news is that you only need to look at this four times a year.

Set up a spreadsheet where you track key numbers like Price, Earnings, Current/Total Assets and Current/Total Liabilities.

You can do it like this:

With just these five indicators you will be able to draw conclusions about the financial health of the companies that you are following.

Have they had an exceptionally bad/good quarter and why is that?

Then after a few quarters you will understand the Balance sheet better.

You will know how the companies are making their money and you will be able to calculate ratios like Working capital (Current assets – Current liabilities), Equity (using the Fundamental accounting equation) and the Price to earnings ratio.

Conclusion:

One of the best ways to start investing is to follow a handful of companies. In the US companies traded on the stock exchange are required by law to submit a financial report every quarter.

Just keep track of the companies’ earnings, their assets and their liabilities and you are on your way to become a financial analyst.

 

 

 

Get rich slowly

To get rich slowly is both easy and difficult.

Today I want to talk about getting rich, but not in the sense of winning the lottery, but rather the kind where you are stacking one brick on the other and see your wealth accumulate over time.

We all know that investing requires a good amount of patience.

It’s not for everyone.

Some people are naturally inclined to bet everything they own on just one horse – and that is perfectly fine – while others prefer to save their money.

We could not all be savers. Not only would that be boring, but also the economy needs some of us to spend while others can save.

If you want to get rich slowly you need to be able to stay calm when the wind blows and you see your securities tumble in value.

Investors vs. speculators

To put this into perspective, there are two different categories of people in the market: the investors and the speculators.

While the speculators are betting their money on a particular stock very much like people do on the racetrack, an investor is taking action from conclusions and hard numbers.

He or she is not moved by flings or hypes about a certain business idea or technology that may or may not be founded in reality.

To an investor what matters are the fundamentals.

It’s those that make investing such an interesting endeavor.

Legendary investor Benjamin Graham defined what investments are like this in his book Security analysis from 1934:

An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

That definition is still valid today.

So what is investing all about?

The essence of investing is to compound the interest paid.

What this means is that you want to reinvest whatever yield you are getting back into the stock.

The goal is of course to see your capital grow, but it really grows much faster if you are compounding the interest.

To illustrate my point, let me show you an example:

Let’s say that we have 100 shares of a company, ABC Corp, and each share costs $100.

If the shares are increasing in value with 5 per cent a year then after five years they will be worth:

After 2 years the value of the stocks will be $11,025 and you’ve made a profit of $1,025.

On the other hand, if we reinvest the dividend in the same stock it will look like this instead:

If we then compare the numbers for Year 2 we can see that in Figure 1 our shares are worth $11,025 whilst in Figure 2 they are worth $11,466.

Depending on how much of your money you invest and the size of the growth these numbers will of course fluctuate. But if you buy back more stock you will compound your interest quicker.

This is in essence what investing is all about.

 

 

 

When is the market overvalued?

As an investor you have a certain responsibility towards yourself as to not buy stock of overvalued companies.

Where does that lead us today when the market on all metrics is overvalued? Do you sell your stock and miss out on the spectacular gains of the final blow-out phase or do you buy more on the assumption that there will always be a greater fool to whom you can sell if things go wrong?

It may seem as though we have left the old paradigms about value behind us, but at the same time we cannot seem to work out a new one either.

The first thing that we need to conclude is that past performance is a very poor guide for the future. Just because the market has been going up with 270 per cent since the depths of the financial crisis there is nothing guaranteeing that this will continue. If you believe this, you also believe that the market will continue up indefinitely, for ever, and that all the declines in the market are just temporary.

Now, it is obvious that if a company repeatedly is showing good financial results, they are likely to continue. That is because a good financial result over time equates to a certain business advantage or “edge” in the market in which it operates. Thus, a good financial result is likely to engender higher prices of the stock.

In fact, the opposite is true. The longer the market has advanced, the higher the probability of it crashing down eventually. We all know that sooner or later this is what happens when prices fall spectacularly.

The second point about an overvalued market is that it matters. The assumption that the price of the general market is irrelevant is wrong. That assumes that you always be able to find cheap, bargain stocks, no matter what the price level of the market is. That is obviously not true. There are times when the market is so highly priced that it’s a fool’s errand to look for cheap value stocks.

Most Wall Street pundits are talking about the advance of the market since the depths of the financial crisis, they don’t mention that those advances have been from extremely depressed levels. That is another reason not to expect the market to continue up.

Another way of looking at the valuation of today’s stock market is to say that the nature of bull runs and subsequent crashes has not changed. In fact this has been the pattern throughout history and there is little to argue for that this situation has changed.

There are many people talking about the current price level of the market who are concluding that the current price of the market is a direct consequence of low interest rates and global central bank policy.

There may be policies that indirectly affect the market, but in the long run the market is a weighing machine that is at least trying to get things right.

The mere idea that the market was undervalued in March of 2009 and is overvalued now tells me that the probability of huge price gyrations are great also in the future.

So this is the take home message: The likelihood of huge swings in the market is always there and it is due to human nature.

 

This article is very much inspired by the wisdom of legendary investor Benjamin Graham and a talk he gave in San Francisco in 1962.

 

 

 

Valuation of gold stocks

In today’s post I want to look at valuation of gold stocks.

The last few days I’ve been trying to wrap my head around how to value gold stocks.

It’s not as easy as just valuing a normal manufacturing company with Debt to equity, Price to earnings or by Price to book value.

This is because of the value of the resources in the ground.

This makes it inevitable to normalize all the values calculated according to either production or reserves that the company has in the ground.

We will then get a number of ratios that are similar, but not identical, to the P/E ratio.

The first thing that we will look at is how to calculate the cash cost per ounce produced.

Calculating the cash cost per ounce.

The cash cost is calculated by subtracting Operational cash flow from Total revenue:

Cash cost = Total revenue – Operational cash flow

To get to grips with what this means we can visualize the subtraction like this:

Which is equivalent to this identity which is used in a normal Income statement:

What we do in Figure 2 is that we simply subtract our Cost of sales from the Total revenue to arrive at Net cash.

Then to calculate the Cash cost per ounce produced we divide with the total production for the year:

Total cash cost per ounce = Total cash cost / Total production

The Total cash cost per ounce is then the number that we will use in the rest of our calculations.

The companies are doing the best they can to obfuscate this, but this is the true cost of producing an ounce of gold, silver or platinum.

 

Estimated operational cash flow

The next thing that we will look at is an estimate of how much money can come into the company through sales of the metal.

If we estimate that the company produces X ounces of metal in the year, the average cost of production is Y $ per ounce and that the average price of the metal is Z $ per ounce then the estimated operational cash flow of the company is:

Estimated operational cash flow (EOCF) = ( Y ($ per ounce) – Z ($ per ounce)) * X (ounces produced)

This number we will use in subsequent valuation calculations.

Price to Cash flow ratio

We can then use the Operational cash flow and calculate a Price to Cash flow ratio where a lower number indicates a cheaper stock.

If, for instance, the Price to Cash flow ratio is 5 then investors are paying $5 for each additional dollar of Cash flow.

Typically this number ranges from 3 x to 30 x and the lower the number the cheaper the stock.

Market cap to Forecast production ratio

We can also use the the Market cap to figure out a valuation to forecast production ratio.

Here again the lower this number gets, the lower the stock is valued in the market.

Typically this number ranges from about $1000 per ounce to $25,000 per ounce.

The lower the Market cap is per ounce of forecast production the cheaper the stock.

 

Market cap to reserves ratio

What we look at here is the Valuation (or the Market cap) and divide with the total number of ounces that the company has in reserves.

This number typically ranges from $100 to $1000 depending on the location of the resource.

Again this is a valuation metric where a lower number is cheaper.

 

Price to Earnings ratio

This is the classic valuation ratio where the price of the stock is divided by the earnings.

For gold stocks this number is usually higher than for ordinary stocks and a number of 50 is not unusual.

The lower the number the cheaper the stock.

The question then of course becomes:

How can it be that the Gold stocks are so expensive that investors are gladly paying 50 times earnings to get it?

The reason is that investors are paying for the gold reserves and the gold production that the company have.

The equity valuation is just a part of the value.

 

Examples

So that you better understand what I mean when I talk about the value of different gold stocks, I will now give some examples:

The first is of a hypothetical gold mine ABC Gold Inc. that has the following Cash flow and Income statement:

We then hit Enter and we get the result that we want in cell B6 ($1360,000,000).

Then we continue to calculate the Cash cost per ounce by dividing B6 with B5:

Here again we hit Enter and we get the Cash cost per ounce in cell B7:

So what do we do with these numbers?

Well the first thing we can do is to calculate the Estimated operational cash flow at a given gold price:

Let’s say that we estimate that the average gold price will be $1350 per ounce in 2017, the Total cash cost per ounce was $817 in 2016 and that the company forecasts a production of 1,725,000 ounces in 2017, then the Estimated operational cash flow per ounce will be:

We then see that the Estimated cash flow per ounce is $533 and to get to the Estimated operational cash flow we multiply B12 with B10:

The result is of course as in Figure 9:

 

Conclusion:

In today’s post we have been looking at the valuation of gold stocks as a function of their production and reserves in the ground.

 

 

 

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