Invest like a Guru according to Charlie Tian

first posted: 2024-09-17 06:25:21.875068

Invest like a Guru is a book publishes by Charles Tian in 2017. The author created the website gurufocus after sustaining significant losses in the 2000 bubble: he bought optic fiber companies, which turned out to have malinvested, and much of the optic fiber was dark for many years.

Gurus

Peter Lynch

Principles:

Fast growers: in deciding between Starbucks and Blockbusters in 2001, author chose Starbucks as earnings grew 30% yoy and BB was losing money 4 years out of 5.
Stalwarts: companies with no or low debt compared to cash of fcf
Slow growers: go for a business any idiot can run
Cyclicals
Turnarounds
Asset plays

Warren Buffet

Better buy a wonderful company at a fair price than a fair company at a wonderful price.

Wonderful companies:

broad and durable moat, a competitive advantage
low capex and hight return on capital
earning per share growth
a very attractive price (1977), an attractive price (1992), a fair price now
against diversification: against having 20 stocks

Holding period is forever: gains from growth are much higher than from valuation convergence.

Donald Yacktman

Thinking in terms of rate of return of the stock like bonds.

avoid cyclicals, prefer short customer repurchase cycle such as consumer staples
generate cash while growing, low need for debt
governance: Yacktman expects 1) reinvest 2) aquire 3) buyback 4) reduce debt 5) dividends
hurdle rate: comput forward rate of return in 7y

Other Gurus:

Howard Marks
Jeremy Grantham
Bill Nygren
Robert Rodrigues
Steven Romick

Deep Value is a High Risk Strategy

Few definitions:

tangible book value: (total asset - total liab - preferred - intangible)/shares outstanding
net current asset value: (current asset - total liab - preferred)/shares outstanding
net current working capital: (cash and short term inv + 0.75(account rec)+0.5 inventory - total liab - preferred)/shares outstanding
net cash (cash and short term inv - total liab - preferred)/shares outstanding

Teachings of 2008

Net cash is the most conservative. It is easy to produce these numbers and use them to screen stocks. In the US, this led to 20 stocks with average overperformance when applied in 2008 over 1Y.

However, except in 2008, there are very few companies with net cash above price, and those companies always tend to underperform the SP500. If you build the portfolio this way, you need to get out of the position within one year. Unlike wonderful businesses whose value grow with time, these deep value bargains tend to see their value erode with time.

Not only is investing in deep value riskier with time, but it entails higher capital gains tax for US investors, and the low quality of companies selected can be anxiogenic.

Buy Only Good Companies

companies that had 10y of profit out of 10 last have better price perf outcome than 9 out of 10 etc... also check operating margin consistency
check for 20%+ ROIC and 20%+ ROE
check for consistent double-digit growth
company operations should be stable over 5 to 10y
interest coverage should be below 5

How to Find Good Companies

Asset Plays: when corp owns something valuable, this is very risky as book value is unrelated to value unless the asset is operating
Turnarounds: lynch made money from companies badly managed that get better, Buffet never had success with those
Cyclicals: auto, airlines, steel, oila and gas, chemicals, housing. Cyclicals are less rewarding, leveraged cyclicals are truly dangerous
slow growers: large mature companies are good for dividend portfolio, but otherwise avoid
stalwarts: middle size company with 15% growth and good management and profitability: these are the ideal investments
fast grower: small size 20% growth company

A few more considerations:

Basic Material, Energy, and Consumer Cyclical revenue fluctuates lightly, leading to massive net income dip on down years. The losses are deep and impact the whole cycle, despite being concentrated in a year.
Tech companies often have big asset investments. Msft and Google managed to get a moat.
Banks have massive leverage of 20:1 that magnifies any mistake, accounting disclosures that are insufficient to assess risk, and institutional imperative to follow the herd like lemmings. For Buffet and Munger, it is all about their ability to identify good bank management. For Peter Lynch, it was about small community banks and savings and loans that have a simpler business.
Healthcare and Consumer Staples are less cycle sensitive, investor Tom Russo became famous by parking 60% of his portfolio into Nestle, Heineken, Annheuser Bush, Pernod-Ricard, Philip Morris and Altria.
Retail has many shooting stars with stellar growth followed by decline all the way to bankruptcy. There is little moat in retail.

Shooting Stars vs Shooting fish in a barrel

the best performances are to be found in biotech and software microcap
biotech usually with 100m with no revenue, median stock return is -28%, 20% go to 0, not owning the winner leads to big loss
software has 5% bankruptcy, with median perf of 35% over 10 years.

Buying at a Fair Price

A intrinsic value formula based on growth phase value and lower growth value is calculated as $$E(0) \frac{1-x^n}{1-x} + E(0) x^n y \frac{1-y^m}{1-y}$$ using the following conventions:

growth phase factor $x = (1+g)/(1+d)$
terminal phase factor $y = (1+t)/(1+d)$
$d$ discount rate, $t$ terminal growth, $g$ early growth, $n$ early phase duration, $m$ late phase duration
$g=$20% or it is current growth capped at 20%, $t=$4%, $m=n=10$, $d=$12%

Price formula assumes that all earnings are distributed to the owner without tax as soon as they are earned. Author prefers to use earnings rather than FCF as FCF can be significantly lower on years when investments occur.

Author mentions that $d$ should theoretically be a wacc, which would be much lower than 12%, though his assumption that all earnings are distributed seems heroic. He also suggest to use alternative investment returns as hurdle rate $d$.

Finally, he is suggesting to add cash and eq or some current assets to the discounted earnings valuation, although much of this cash is often not remitted and therefore subject to heavy taxes (35% corporate taxes and 30% dividend tax).

Good Company Checklist

financial strength: interest coverage, debt/rev ratio, altman zscore
profitability: operating margin, piotroski F-score, trend of op margin, consistency of profitability
revenue growth: 10y, 5y, 3y, 1y
operating losses: any losses in last 10y
gross margin growth, operating margin growth
asset growth faster than revenue growth

GMO James Montier advised to avoid companies with

stocks at high P/S ratio
low piotroski score
double digit asset growth

Other negative signals to check out for:

reducing day sales outstanding
days sales of inventory
Buffet 86 owner earnings diverging from reported earnings.
divergence between net income and free cashflow
cost of capital higher than roic
issuance of debt
issuance of new shares
altman z-score
piotroski score
beneish m-score
sloan ratio
interest coverage
dividend payout ratio
short percentage of float
div yield relative to historical
stock price relative to historical
valuation ratios: P/E, P/B, P/S relative to historical avg
Higher forward P/E (red flag)
Buyback track record
Insiders selling, none buying
Low tax rate

Postive signals:

profit margin growth
share buybacks
raising dividends
paying down debt
insider buying

Failures, Errors and Value Traps

The wrong companies are:

company with a hot product or a bright future (eg, peloton, tesla, solar city)
hot product that everyone is buying (crocs, aeropostale)
peak cycle (buying oil co when oil is expensive)
growing fast: like Starbucks or Krispy Kreme back in 2000, can't get skilled workers
aggressive serial aquirer: drug company financing aquisitions with debt
business too competitive: mobile phones, kmart, ...
desperate to gain market share: watch out for insurance and banks
facing regulatory changes: education companies getting reviewed by govt as students can't pay their loans
becomes ossified: blackberry, kodak, blockbusters

Value Traps:

stock looks cheap relative to earnings
lots of assets but liquidation is off the board, management hopes for a turnaround

The indicia are:

first margin deteriorates, revenue keeps growing, earning grows
then revenue growth slows down, earning stop growing
then earnings drops
then revenue and earnings drop

Avoid trading shorts (max profit is 100% and the position gets larger as bet sours). Avoid options unless selling put to buy stocks, selling calls to sell stocks.

Valuation

P/E is volatile because earnings change depending on the year
P/B is recommended for financials, as earnings depend too much on loss assumptions
using Shiller CAPE is also improving evaluations
Graham formula is geometric average of 1.5xB and 15xE
Peter Lynch fair value is P/E = Growth
earning power value EPV from Colombia Pr Bruce Greenwald EPV = Normalized earning/WACC
author advises to use median P/S instead for airlines and other cyclicals
forward rate of return = FCF yield + growth

Market Cycles

Over the long run, equities go up, never bet against that
Margin tends to be cyclical, with regular crunches
Long term Shiller P/E is 16.7, 10y estimate can be computed assuming reversion of the Shiller P/E to the mean. This does not bode well for the 2017-2027 period
Total MktCap/GDP is a good indicator of valuation, it seems high right now
Insider sales tend to happen all the time, insider buys show genuine value, Buy/Sale ratio above 0.5 show that there is good opportunity in the market.