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TABLE OF CONTENTS
- FOREWORD
- PART 1 - GENERAL INTRODUCTION TO INVESTING
Crash course on what the stock market hubbub is all about.
- PART 2 - BECOMING AN INTELLIGENT INVESTOR
How to act like an intelligent investor--including what to do if you're not one.
- PART 3 - THE PHILOSOPHY OF AN INTELLIGENT INVESTOR
Guiding principles and a brief history of value-oriented investing.
- PART 4 - UNDERSTANDING A COMPANY
In-depth look at Activision-Blizzard (ATVI) the maker of Starcraft.
- PART 5 - IDENTIFYING INTRINSIC VALUE
Explore what "value" really means, and determine whether ATVI is a good investment.
- PART 6 - ADDITIONAL RESOURCES
Glossary, short bios of rich people, further reading, investing simulators.
- DISCLAIMER and ACKNOWLEDGMENTS
Where I make sure I'm not legally accountable for any permanent capital losses.
FOREWORD
The financial world has always had an aura of mystery intangibility. Obscured from the eyes of the general populace, Wall Street’s army of financial professionals tangle with beasts that seem far removed from the day to day lives of those on Main Street. The central battlefield: the stock market.
These days, everybody knows what the stock market is. Most can probably name the symbol of some stock, and some even participate--throwing their lots in with the scrolling tickers that are the life-signs of the market. These people call themselves investors.
Still, most people don’t know very much about the stock market beyond the fact that it seems to be very important and integral to the state of the general economy. Even those who know a little probably still consider the stock market the realm of the arcane and the esoteric, understandable only to the legions of greedy investment bankers and asset managers that spawn in the sewers of Manhattan.
The first purpose of this guide is to tear down the wall of ignorance that the financial world maintains between itself and the rest of the world. The second purpose of this guide is to describe a framework by which the individual can also become successful in the financial world.
PART 1: GENERAL INTRODUCTION TO INVESTING
WHAT IS THE STOCK MARKET?
This is actually a two part question: What is a stock? and What is a market?
Stocks
A stock is a certificate that entitles the holder to an ownership stake in a company. This is absolutely critical to remember. A stock is not a magical symbol. It is not a floating number. It is not a random business “idea”; it is a percentage of a business.
An example: Company ABC issues two shares of stock for John and Joan. John owns one share and Joan owns the other. That means both John and Joan own 50% of Company ABC. Let’s assume Company ABC owns two chairs, which can be rented out for $1 per day each. That means at the end of one year, Company ABC has earned $365 x 2 = $730. Of those earnings, John and Joan are both entitled to half. Say, at the end of that year, John and Joan have a falling out and decide they don’t want to run Company ABC anymore, so they decide to liquidate. Company ABC sells the chairs for a total of $10 and both John and Joan walk away with $5.
Of course, most companies are not comprised of just chairs. Most companies own equipment, factories, properties, inventories, and other assets; and they earn profits that come from activities beyond simply renting out their assets. Nonetheless, the shareholders own an interest in both the assets and the earnings of the companies which issued them stock, just as John and Joan each owned 50% of Company ABC.
Google, as an example, has 315.94 million shares. That means if I were to buy a share of Google, I would own 0.0000003% of all of Google’s assets ($31 billion), liabilities ($3.5 billion), and profits for that year ($4 billion) as well as all future profits while I continue to hold Google’s stock.
Remember remember remember: if you own stock, you own a company.
[Note: There is no other way to own a company but to buy its stock. CEOs, COOs, CFOs, presidents, vice presidents, directors, managers, all the way down to the lowly wage slave—these are all employees. None of these individuals are the owners of the companies which they help run unless they also hold the company’s stock (which they either bought on the stock market, or were given by the company for their performance).
Also, for the curious, companies issue stocks to raise money. They could borrow the money (use debt), but they’d have to pay it back. Issuing stocks (using equity) means that the company does not have to pay back the money it raises. It does, however, have to let the person who bought its stock share in on the profits. This is why certain companies that do not require the capital (the more official term for money) will remain private companies, and will not issue their shares to the general public.]
Markets
A market is a place where individuals meet to buy or sell their property. If you go to a fish market, you can buy salmon, tuna, catfish, etc. If you go to a stock market, you can buy partial ownership in Microsoft, Activision-Blizzard, Wal-Mart, Target, etc. The market is a way for prices to be determined for the property being sold. Since the property in a stock market is essentially companies, the stock market is essentially a pricing mechanism for companies. The market capitalization (which is equal to the total number of shares x price of each share) is the price that the market thinks the company is worth. Google’s market capitalization is $140 billion, and you can buy a 0.0000003% piece of it for $444.
It is important to note, though, that the stock price is simply the current price at which the stock is being offered. It is NOT the value of the stock. This is also a critical concept. If you go to the mall and there’s a shirt that you’ve been eyeing but it costs $10 and you’re cheap as hell and you don’t want to pay that much, what do you do? You wait for a sale so that you can buy it at $5. Why? Because the price is cheaper. Because, maybe, the store wanted to get rid of those shirts but it couldn’t sell them at the higher price so it had to lower the price. And you buy at the lower price because nothing else has changed. The shirt hasn’t changed—you like the shirt at $5 just as much as you like it at $10, more, perhaps, because it cost you less. That’s what a stock price is--it is just the price at which you can buy the stock.
The stock price, the market’s price, is NOT the stock’s value. It is the price at which you can buy the value. Just as the shirt was valued somewhere below $10 and somewhere above $5, a stock’s value does not change (not day to day, anyway), its price does. Again, price is NOT value. It may reflect the value, it may be influenced by the value, but it is NOT value.
[Note: There are many other types of financial markets out there, from ones that trade simple commodities like rice and gold to ones that trade exotic financial instruments like derivatives and swaps. The stock market, however, deals exclusively in stocks—percentage stakes in businesses. When you buy a stock, you own a business.]
WHAT IS INVESTING?
Investing is the simple concept of putting resources into something today in the hopes of creating benefits in the future. In the financial world, that means putting money into an asset today to generate returns in the future. There are many types of assets but it is now generally accepted that stocks (or equities, as they are also known) generate higher long-term returns than any other asset class (other asset classes being bonds, real estate, currency, precious metals, etc.).
There are many different stock investing strategies, and I will give a brief overview here. The broadest separation of investing strategies is between fundamental analysis and technical analysis. Within fundamental analysis there is macro analysis (“top-down”) and micro analysis (“bottom-up”). Within the bottom-up analysis group there is also a distinction between “growth investing” and “value investing”. Finally, there is simply “intelligent investing”, which will be the dominant theme of the remainder of this guide.
Fundamental analysis
Fundamentalists believe that the stock price reflects some underlying truths about the business. A fundamentalist would care about whether or not a company was able to sign new customers, whether the company was in a significant amount of debt or not, whether the company had fired the lousy CEO who was consistently producing sub-par results, etc.
Technical analysis
Technical analysts believe that all information about a stock is reflected in the price. Technical analysis looks only at the historical price chart of a stock to determine how the future movement of the stock will progress. If a stock, for instance, moves above its 52-week high, a technical analyst may say the stock is moving into uncharted territory (literally) and that the stock will most likely have to come down in the near future—nevermind that the price increase is because of record-breaking sales and earnings and cost-cutting that is more efficient than ever.
[Note: Technical analysis is, in the eyes of this author, more or less a pseudoscience, and there is no successful money manager that the author is aware of that earns a living based on accurate predictions from charting. Thus, this will be the last mention of technical analysis in this guide.]
Top-down analysis
Top-down analysis is a type of fundamental analysis that looks at macroeconomic situations and extrapolates those out to potential investment opportunities. When George W. Bush was elected president, for instance, a top-down investor might have said, there’s a good possibility we’re going to go to war with Iraq here, which would limit our oil supply, would would increase oil prices, which would be good for oil companies, so I’ll buy some shares in ExxonMobil.
Most hedge funds don’t operate completely off top-down analysis, but many do consider it a component in their investment decision making. Top-down analysis contains a lot of variables which make it very, very, very difficult to project the direction an economy is going to proceed in.
[Note: Individual investors can participate in top-down analysis investing by buying an assortment of funds (mutual funds, exchange-traded funds, index funds, closed-end funds) which reflect the macroeconomic trends that they believe will be occurring. For instance, I might buy a Japanese index fund if I believe that Japan will be exporting a significant amount in the future.]
Bottom-up analysis
Bottom-up analysis is a type of fundamental analysis that looks at individual companies on a microeconomic level. A bottom-up investor will look at ExxonMobil and ask, how much market share does this company have, how much of a brand name and how much company loyalty does it command? Does the company have a strong balance sheet (lots of cash, not a lot of debt, for instance), does the company have strong earnings prospects for the future?
Any investor who is seriously interested in stock market investing will have to practice bottom-up analysis in some varying degree. Remember, if you buy a stock, you are buying a company—if you are buying the company, you should at least put as much thought into understanding the company as you would into buying a new car, a new video game, or even your next meal (as some stocks cost just as much).
Growth investing
Growth investors are fundamental, bottom-up analysts who look for stocks that will be able to grow earnings consistently over the coming years. Growth stocks generally have high prices relative to earnings, as investors price their future potential into their current prices. They usually do not have a lot of operating history, but have a lot of potential to become something big. Amazon, Google, Microsoft, Amgen—most tech. and biotech. companies at one point in their life were probably considered growth stocks. The father of growth investing is generally considered Philip Fisher.
Value investing
Value investors are fundamental, bottom-up analysts that go bargain shopping. Value stocks are generally stable, dividend-yielding, and cheap relative to their earnings. A value investor will look at companies that nobody has ever heard of engaged in businesses that nobody would want to know about. They’ll look at the company’s balance sheet to find $50 million of cash and they’ll buy when the market prices the entire company at $25 million (actually, any sane investor would take that deal, but nowadays these buy $2 dollars for $1 deals are practically nonexistent).
“Intelligent investing” or “value-oriented investing”
These are the terms that I will use to describe the strategies born of Benjamin Graham and David Dodd and nurtured to perfection by Warren Buffett--currently the world’s second richest man, and the only man in the top 100 who made his entire living from investing.
The term “intelligent investing” comes from Benjamin Graham’s seminal text The Intelligent Investor, which lays the philosophical foundation for this investing strategy. And the term “value-oriented investing” is distinct from value investing insofar as value investing is concerned with absolute benchmarks of cheapness (low price-to-earnings ratio, low price-to-book ratio, etc.), value-oriented investing is concerned with relative measures of cheapness (is the price you pay cheap considering all future earnings you can expect to take out, etc.).
The following parts of this guide will be devoted to discussing in detail what this strategy entails and how one become a successful practitioner of it.
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PART 2: BECOMING AN INTELLIGENT INVESTOR
WHO IS AN INTELLIGENT INVESTOR?
The investor, as opposed to the speculator, is interested in sure things. The investor is interested in putting $5 down today when he is reasonably certain he can make $10 tomorrow. The investor is honest with himself about what he knows and doesn’t, and realizes that it’s his money on the line if he’s wrong. The investor is not interested in what could potentially happen; he is interested in what is almost certainly going to happen.
More than anything, the investor must be willing to learn. To own a company, and to be able to sleep well at night with so much of his money tied up in that one company, the investor must be interested in knowing. He must know a company better than the company’s employees, better than the company’s customers, and better than most of the company’s other owners—because his investment decision will be based on how the company interacts with all three of these constituencies. To know this company, the investor must be willing to learn as much as he can about it.
The investor is not a genius (genius may in fact impair investing skill). He is, however, rational, calculating, disciplined, and patient. His IQ is not as important as his EQ. He is an independent thinker. He must be able to stand apart from the crowd (especially since that’s how he’ll make all his money). He must not judge his self-worth based on what others think of him; he must have an Inner Scorecard by which he values himself, just as he will value investment opportunities based on their intrinsic value as opposed to their market price.
The investor is not stubborn. He does not have his ego tied up in his money. He makes an investment decision (buy, hold, or sell) based on what he thinks it will do for his returns, not based on how it will make him look. He will admit it when he’s wrong, and he will not gloat when he is right. He is interested in objective realities.
WHAT SHOULD THE INTELLIGENT INVESTOR DO?
The first thing the intelligent investor needs to do is admit his level of competency.
You don’t have what it takes
If most of Part 1 was new to you and you looked at the description above of who an intelligent investor is and it doesn’t sound like you, then admit it and move on. I’m not 6’7” and I can’t dunk a basketball; I’m not trying out for the Lakers. Know yourself, know your limits, and play to your strengths. There’s no shame in being the best bubblegum blower in the world--it’s better than being yet another mediocre blue suit and tie with a life full of regrets.
[Note: I should also mention, most people who think they can invest, can’t. 70%-85% of professional money managers underperform the market average (source). That means you could’ve done better by putting your money in an index fund and falling asleep for most of your life than these guys did spending their every waking moment trying to beat the market.]
That doesn’t mean you can’t still invest though. It just suggests that perhaps you weren’t cut out for actively investing your own (or anybody else’s) money. You should still put your money to work though. For the past century, inflation has increased at a long-term rate of 3% per year, meaning that your $100 today is worth less and less as the years go by. The longer you leave your money under your pillow (or the financial equivalent of that—in a savings account), the more money you’re losing.
You have to invest just to beat inflation, just to stay neutral. You can put it in gold, you can put it in bonds, you can even buy property and become a real estate investor, but nothing is going to snag you returns over the long-run as well as equities. I’ve heard a lot of arguments from all types of people who simply don’t trust stocks and say that you need to put your money into something tangible like gold, but that’s the financial equivalent of Creationism—it’s just factually and objectively wrong. Gold’s value is market determined just as much as stock values. And when the world goes to hell, gold won’t save your ass any better than a bunch of paper certificates, and at least you can use the latter as toilet paper.
Also, don’t put your money into a mutual fund, hedge fund, closed-end fund, exchange-traded fund, or any other fund that takes a management fee. There are two reasons for this. Firstly, those guys often earn money based on the amount of money they manage, not based on the performance they generate, so their incentives are simply to manage more money, not to earn better returns on the money they already manage.
[Note: Hedge funds, for instance, charge the infamous 2 and 20; which is 2% of all managed fees and 20% of all profits above a certain hurdle rate, say 6% above the S&P 500, a standard benchmark of performance. Most hedge funds can’t consistently perform above the hurdle and count on the 2% management fee to keep funding their new exotic cars, exotic vacations, exotic mistresses, and their exotic egos.]
Secondly, the Efficient Market Hypothesis, which, in as few words as possible, boils down to the statement that when a lot of smart people attempt to beat the market average, they become the market average. The EMH postulates that the market is so efficient that there are never or rarely any (depending on whether you subscribe to the strong, weak, or semi-strong version of the EMH) pricing discrepancies from which an investor could profit off of. So, for instance, if GOOG was trading at $300 and I thought it should be worth $500, I would try to buy a large amount at $300 so that I could later sell it. EMH postulates that if I possessed the information to notice the undervaluation, then someone (or everyone) else would also possess it, and then everybody would realize GOOG was worth $500, and nobody would sell at $300 (or if they did, there’d be a million other buyers so I’d only be able to get a small amount at $300 and I wouldn’t be able to profit that much anyway).
The EMH in its most extreme form, where nobody could ever earn returns higher than the market average, is bullshit, simply because information dispersal is not that perfect yet that data can travel instantaneously as if we were all psychically linked. Still, the EMH is right a large percentage of the time, and most of the time, an active manager is not going to outperform the market.
So unless you can convince Peter Lynch to rejoin Fidelity, put your money into an index fund that simply seeks to mimic the market. Vanguard’s founder Jack Bogle pioneered the idea of a no sales fee, no redemption fee, minimum maintenance fee (< 0.5%) index fund. Look there to start.
Warren Buffett noted that, “Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” If you’re smart enough to admit that you will never be “smart money”, you will most likely end up better off in the long-run than those who delude themselves into thinking otherwise.
You have what it takes
If you’ve gotten this far and you still think that you’re that one in a million who was predestined to be an investing machine, just that you’ve never realized it before, then you must first admit that you aren’t yet an intelligent investor before you can continue. That’s not to say you’ll never become one; that’s not to say that you can’t very quickly learn and improve and develop into the next Warren Buffett; but that is to say that you will NOT be ready to invest intelligently after just reading this one guide.
That doesn’t mean you should stop reading, however. But it does suggest that you might want to avoid putting a significant amount of money into any single investment opportunity until you further develop your skills. There is no shame in not knowing enough—that’s something that you can gradually improve upon. But you don’t want to be wrong in investing—that can cost you. The mathematics of investing are such that if you lose 50% of your money, you will have to then make a gain of 100% to get back to neutral. That’s not easy, and a lot of funds and a lot of careers fold because of it.
If you’re serious about becoming an intelligent investor, then I repeat, always always always continue learning. Never overestimate yourself, and be willing to err on the side of undervaluation (of yourself, and of investments).
Everyone
I encourage everyone to get interested in the stock market and the financial world, even if they may not feel personally suited for it. There are investing simulators where you can invest with virtual cash just to play around and experiment. The two best that I've found are the Investopedia stock simulator and The Motley Fools - CAPS.
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PART 3: THE PHILOSOPHY OF AN INTELLIGENT INVESTOR
Benjamin Graham’s “Cigar Butts”
The manifesto of intelligent investing is Benjamin Graham’s The Intelligent Investor, which every serious investor, intelligent or not, should read at least once in his lifetime. Perhaps now is not the time, I did not read The Intelligent Investor until I had already become quite familiar with the modern day value-oriented investor, but at some point, everybody should read it.
Ben Graham essentially argues that the investor is the individual who looks at a stock as representing a piece of a company, and not as simply a number which arbitrarily goes up or down. He was interested in understanding a company to the point where he could attribute to it an intrinsic value. There were a few ways by which he would come to this value but ultimately, his investment decisions were based on a simple comparison between the stock’s market price and its intrinsic value. This investment algorithm is the central tenant of value-oriented investment:
1) Determine intrinsic value
2) Compare to market price
3) Buy if price is less than value
4) Hold until price reaches value
The hard part, of course, is step 1, determining intrinsic value. In his book, Graham mentions the ability to value a company based on its earnings power (a concept I will explore in detail later), but in practice, he focused almost entirely on asset value. Essentially, Graham wanted to buy $2 for $1. He wanted to find companies where, either the cash in the company was more than the price at which the entire company could be bought for (in essence, buying a piggybank for less than the money inside), or he wanted to find companies that could be liquidated and its parts sold at a greater price than the price for the entire company as a whole. If, for instance—back to Company ABC and John and Joan—John and Joan would both be willing to sell their share in Company ABC for $10 each, meaning that Company ABC was worth $20 by market price, but the two chairs that Company ABC owned could be sold at a garage sale for at least $15 each—that would grab Graham’s attention. He’d buy the company for $20, then sell the chairs for $30, and nab a nice 50% return on investment.
He didn’t care about any of the qualitative components to a company: does it run well, is it in a good industry, does it have customer loyalty, etc. He just wanted to know if he could buy it at less than it was materially worth. These stocks became known as “cigar butts”, the ends of used and unwanted cigars found on floors and sidewalks which can be picked up for cheap and which contain one or two last puffs.
His style was very mechanical. He rarely met a company’s management. He bought based solely on the numbers. He had lived through the Great Depression and developed his conservative style to deal with the risks inherent in the stock market. He believed in two principles: diversification and margin of safety. Diversification was necessary; since he was uninterested in the qualitative aspects of a company, he was not aware of the underlying factors that affected a company’s movements. A few companies sold as cheap as they did because they truly were trash. By diversifying, Graham made sure that the terrible performance of a few could be counteracted by the overall strength of the rest.
The margin of safety is a concept that Warren Buffett, Graham’s most famous and most successful disciple, considers as his most important contribution to investing. The margin of safety simply says that the investor should always give himself a little buffer to be wrong. So if he thinks a company is worth $10, he should only be willing to pay $6 or $7 for it.
Finally, Graham invested for the long-term. Even to him, the mechanism by which a stock will rise from an undervaluing market price to its intrinsic value was unknown; he only knew that on most occasions, it simply did. Investing had to be done with a long-term horizon (in Graham’s case, 1-3 years), otherwise the market simply couldn’t keep up with what he identified.
Following these strategies, Graham’s hedge fund was able to return 17% annually from its inception until its close. Walter Schloss, one of Graham’s disciples who continued to invest exactly as Graham had taught, managed returns of 21.3% vs. the S&P 500’s 8.4% (a common market benchmark) over a 28 year period. 21.3% compounded over 28 years would turn $1,000 into $23 million. The S&P’s 8.4% compounded over 28 years would turn $1,000 into only $887,000 (source).
Warren Buffett’s Growth and Value Synthesis
Warren Buffett earned his MBA from Columbia University where he was a student of Ben Graham’s. Later, Buffett worked at Graham’s hedge fund until Graham closed down in 1956. In 1957, Buffett returned to Omaha to start his own investment partnership, gathering $100,000 from friends and family and investing it in the same cigar butts that Graham had. Buffett ran his partnership until 1969, when he closed it down because he believed he could not find any other investment opportunities (Buffett earned his keep based on a 0% management fee and a 25% performance fee, he only made money if he could earn a return better than 6% every year). From then on, Buffett turned his attention to a terrible textile company called Berkshire Hathaway; it was one of his worst investments ever, but also his most legendary.
Buffett’s investment strategy has changed considerably in his 30+ years of running Berkshire Hathaway. Nowadays, his company is one of the largest companies in the world, and the investments he makes are huge multi-billion dollar acquisitions of whole companies—otherwise they don’t even make a dent in his returns. There are a lot of resources that talk about how he invests now, but to be honest, it simply isn’t applicable to the individual investor, who doesn’t command a Titanic reserve of capital. That’s not to say there aren’t important lessons there though. The key is to parse it out.
Buffett’s greatest contribution to value-oriented investing was identifying the importance of quality in making an investment decision. Graham paid lip service to earnings, but he was not as concerned with what a company made in profit as he was concerned with what the company owned. Even less would he be concerned, if at all, with how a company could potentially do in the future. All that concerned Graham was the here and now--what was of tangible value today which was selling at a lower price than its value. For years, that distinction continued to rule in investor’s minds. Value stocks, like the cigar butts that Graham scrounged for, were fundamentally different from the growth stocks that emphasized future earnings and future potential. Buffett, in his partnership years, believed in this distinction, but fortunately, he eventually saw through the haze and realized that “growth was always a component in the calculation of value”. (I will explain this in the valuation section further down).
The second contribution that Buffett made was that once he recognized the importance of growth in determining intrinsic value, he realized the importance of identifying good businesses—businesses with certain competitive advantages, or moats, which warranted them a premium value. These competitive advantages, such as lower cost structures, better management, enduring brand names, etc., made it difficult for competing businesses to replicate the company’s success, and strengthened the company’s ability to generate high levels of profit.
The third contribution that Buffett made was a complete reversal of Graham’s theory of diversification. Buffett essentially said, if I’m willing to put $1 into this investment opportunity, then I should be willing to put $100, and if I’d be willing to lose $100, I should be willing to lose $1,000, etc. etc. He did not fear losing money because he had done the analysis to make sure that he wasn’t at risk. “Wide diversification is only required when investors do not understand what they’re doing.” Buffett, instead, accepted a huge amount of concentration, putting up to 40% of his fund’s capital into one idea. In other words, he was comfortable holding a portfolio of less than 5 stocks. Like Mark Twain said, rather than keep your eggs in separate baskets, keep them all in one and watch that one very closely.
The fourth contribution Buffett made was what tied his whole strategy together: the circle of competence. Buffett was willing to put so much into so few stocks because he was absolutely sure he understood those stocks. Buffett understood his limitations and refused to stray from them. When the dot-com bubble began to form and people were becoming millionaires overnight, Buffett was mocked as being old and behind the times because he refused (and continues to refuse) to invest in tech. stocks—he claimed he didn’t understand their business model. Of course, as it turns out, neither did most of the people investing in them….
Modern value-oriented investing
Modern value-oriented investing is still practiced in more or less the same manner Graham did in his hedge fund years, or Buffett did in his earlier Berkshire Hathaway days, or some combination of the two styles. The same principles remain: determine intrinsic value, buy with a margin of safety, think long-term, look for quality, look for moats, don’t be afraid of concentration, and always always always stay within your circle of competence.
More explicitly, the intelligent investor is looking for pricing discrepancies. The market is usually, but not always, a good judge of value, simply because there are so many smart people out there all using the same models and running the same numbers—for the most part, EMH is correct, and if you’ve been able to crunch the numbers to come to a reasonable valuation, then someone else out there probably has as well. Occasionally, however, there are moments when the market will misprice a stock. In the past few months, for instance, the economic crisis has dragged down a lot of stocks from their previous highs for no fundamental reason (reasons that originate from a change in the underlying company). Macroeconomic forces such as a tightening of lending and a global fear and pessimism ran throughout the financial world, causing a lot of large investors to sell stocks which they would have otherwise held onto. The intelligent investor waits precisely for this kind of opportunity.
The key, though, is that the intelligent investor does NOT try to time the market. The intelligent investor is only interested in one thing: buying at a discount to intrinsic value. He can buy during a stock bubble or he can buy during a depression, it doesn’t matter when he does it, as long as the price is right.
The fact of the matter, though, is that there simply aren’t always that many great investment opportunities, and many times, the value-oriented investor will just sit on the sidelines waiting to make a move. That’s ok. Investing isn’t about the quantity of actions that you take; it’s simply about being prepared and ready to make big moves when the odds are in your favor.
The individual intelligent investor
Investing is an interesting game in which it gets harder and harder the bigger and better you get. Professional money managers that deal with large multi-billion dollar funds have a structural disadvantage compared to the small, personal investor.
There are a few reasons for this:
1) Size - As I mentioned before, guys like Warren Buffett have to make huge moves just to make a dent, and there simply aren’t that many opportunities out there at that level. While most funds aren’t the size of Berkshire Hathaway, they are big enough that they might only be able to focus on mid- to large-cap stocks.
2) Timing – Most large, professionally managed funds have a number of investors that they are beholden to. In times of market volatility, these funds may suffer redemptions or other restrictions on capital that the individual investor does not need to worry about. The individual investor can watch his stock plummet 50%, but as long as he has the resolve and confidence in his analysis that the drop is temporary and not permanent, he can wait out the storm and watch his stock go back. Most funds do not have that luxury and in the same circumstance would have to incur permanent capital losses.
3) Mandate – Large funds generally have guiding investment mandates. They can only invest in domestic stocks, for instance, or they can only buy large-cap, or they can only buy stocks of a particular industry. The individual investor is essentially a personal hedge fund—he can do whatever he pleases, as long as the returns are good.
To take full advantage of these structural differences, the individual investor should look into investing exclusively in small-cap stocks that go unnoticed on Wall Street. Wal-Mart and Microsoft have entire armies of analysts researching and covering their every fart and whistle. Smaller companies with market capitalizations under $1 billion or even $500 million oftentimes don’t get as much recognition. That means your competitors (other potential investors and analysts in the stock) are generally less sophisticated and there is a possibility that your rational and disciplined thinking can lead you to spot underlying value where others do not.
Small-caps also have the added advantage of being simple to understand. A large conglomerate like General Electric has a potpourri assortment of divisions and subsidiaries. To understand it, you’d have to be an expert in a variety of industries. Smaller companies are generally only involved in one industry, and they usually have a very simple, easy-to-understand business which can be within your circle of competence.
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PART 4: UNDERSTANDING A COMPANY
Of course, running calculations on arbitrary numbers is just a technical skill, and in the end, the art of investing comes into play in determining whether or not the assumptions that go into the models make sense. That requires understanding the company in whose stock you wish to buy. In this part of the guide I will be walking through a sample analysis of a company that most here should be familiar with: Activision-Blizzard (ATVI).
The great thing is, most of the information that one needs to make an informed investment decision can be accessed for free. Public companies (companies that trade on the stock market) are required to file periodic status updates with the Securities and Exchange Commission (the SEC). The SEC provides these updates to the public free of charge through their online database: EDGAR (http://www.sec.gov/edgar.shtml).
Two types of filings will be the focus of our attention: the annual report (10-Ks) and the quarterly reports (10-Qs). Annual reports are the best way to learn about a company. They provide descriptions of the business as well as the most recent financial data. Quarterly reports are much shorter and are really just quarterly updates of the company’s financial results.
To access ATVI’s SEC filings, we go to http://www.sec.gov/idea/searchidea/companysearch_idea.html, put in “ATVI” in the area where it asks for “CIK or Ticker Symbol”, and we come to this screen:
The red boxed filings are the ones we want to pay attention to: the 10-Q, the 10-K, and the ARS. The ARS is what gets sent out to actual shareholders of the stock. It will contain the entire contents of the 10-K, plus there will usually be some fancy pictures and a letter written by the Chairman of the company (the leader of the stockholders, so to speak, he represents the other owners of the company and is elected from within the owners) and a letter written by the CEO (the chief executive officer, the top manager of the company). Let’s ignore the ARS for now (although ATVI’s has some cool Blizzard games related pictures if you want to check it out yourself) and click on the “Documents” button next to the 10-K.
The document we’re interested in is the “10-K”. It gives itself away with its significantly larger file size.
And here we are:
And the table of contents:
QUALITATIVE
Item 1. Business
This is where the company is going to describe itself and what it does:
![[image loading]](http://img37.imageshack.us/img37/1669/atvibusiness.jpg)
No surprises; ATVI develops, markets, and sells video games. It’s always important, though, just to check and make sure they aren’t engaged in any esoteric business segments that make donkey feathers, for instance. You’d be surprised at how many businesses enter into markets where they have no idea what they’re doing. Fortunately, ATVI seems to stick to what they’re good at.
In 2008, ATVI, formerly just Activision, merged with Blizzard. This was part of their growth strategy to further consolidate and pool strategic resources. They state that they will continue to look for strategic acquisitions and alliances in the future. This is very important for the investor. If we want to assess the intrinsic value of ATVI by predicting how much cash the company will return to us in the future, we need to pay attention to qualitative factors like this which will affect the company’s ability to grow revenues and, eventually, net income.
ATVI further breaks down their business operations into their Activision business and their Blizzard business. Both state that they are concerned with maintaining their brand name and creating strong franchises—an important competitive advantage. Blizzard also mentions that it is interested in further MMORPG and online gameplay development. (We’ll see why further down.)
[Note: This is a good place to mention that the investor should really be wary of overestimating the power of brand names. Brand names, in a business sense, are only important in that they allow the company that owns them to price in a way that their competitors cannot. Customers will pay more for a product with a good brand than for the same product without that brand. In this sense, the brand gives the company a competitive advantage. However, the real issue is whether or not the competitive advantage is sustainable, and most investors tend to overestimate that quality. What they don’t realize is that most brands require a significant amount of money to maintain—sometimes even more than the extra profit the company can earn from it. For instance, the Blizzard brand is a powerful franchise that many people don’t mind ponying up for. However, the brand is founded on a bedrock of immense quality—quality that Blizzard has to spend a lot of money on maintaining. If Blizzard were to release a low-quality game, its brand could easily take a few steps back and lose its appeal. Coca-Cola, on the other hand, has a very durable, sustainable competitive advantage—even though Pepsi regularly beats Coca-Cola in taste tests, people are still attached to the Coca-Cola brand; this is a moat that requires little capital reinvestment from the company to maintain.]
Item 1A: Risk Factors
Careful investors should also take a look at what a company lists as risk factors, although most of these are legalities and experienced investors will eventually be able to discern which are important and which are standard disclaimers.
There are a few lines here that I found interesting:
1) Although we expect that the Business Combination will result in benefits to Activision Blizzard, we may not realize those benefits because of integration difficulties and other challenges.
- This is a common problem and why mergers and acquisitions are not always in the best interest of companies. Sometimes the best way to grow is slow and steady, internally.
2) Our sales may decline substantially without warning and in a brief period of time because a substantial portion of our sales are made to a relatively small number of key customers and because we do not have long-term contracts for the sale of our products.
- In businesses without a strong recurring revenue stream it is very important to constantly produce new, high-quality products.
3) A substantial portion of our revenue and profitability will depend on the subscription-based massively multiplayer online role-playing game category. If we do not maintain our leadership position in this category, our financial results could suffer.
- Fortunately ATVI does have a recurring revenue stream.
4) The future success of our business depends on our ability to release popular products.
5) Our business is "hit" driven. If we do not deliver "hit" titles, or if consumers prefer competing products, our sales could suffer.
6) Our market is subject to rapid technological change, and if we do not adapt to, and appropriately allocate our new resources among, emerging technologies, our revenues would be negatively affected.
Issues 2), 4), 5), and 6) all paint a clearer picture of the type of industry ATVI operates in, and it’s a picture that is worrying to the value-oriented investor. ATVI’s business is predicated on innovation and trend-setting. It’s not augmented by those things, it’s not supported by those things, it’s ENTIRELY DEPENDENT upon them. If ATVI can’t develop the newest and bestest game, ATVI’s earnings will suffer.
Item 7. Management’s Discussion and Analysis of Financial Condition …
This is probably the most important section of all for gaining a qualitative understanding of a company. This is where management is going to give you insight on the operational conditions of a company with as little legal jargon as possible. I encourage everybody to read through this and draw conclusions themselves.
Conclusion
Certainly, ATVI and Blizzard, especially, have a great track record, but past results do not necessarily correlate to future performance. A sophisticated investor will realize that to invest in ATVI would be to invest in the employees at ATVI, in their ability to design better games than their competitors, and in their ability to stay one step ahead. That’s the bet and it’s important to note that. An investment in ATVI is not an investment in a superior business model that is difficult to replicate, it is not an investment in a superior industry with high barriers to entry, it is not an investment in a superior technology that the company has patented and protected from competition; it is an investment in a fast-changing, trend-sensitive business that relies almost entirely on the skills of its employees to distinguish itself. That’s the bet, and that’s the type of judgment that the investor should be able to make after reading a company’s business description.
QUANTITATIVE
Numbers are important in making investment decisions. Financial data for companies come in three major sections: the income statement, the balance sheet, and the cash flow statement. These can all be found in “Item 15. Exhibits and Financial Statement Schedule”.
Balance Sheet
The balance sheet provides a snapshot of the company’s financial condition at a specific moment in time.
A balance sheet shows the “Assets” and “Liabilities” that the company owns.
- Assets are listed in increasing order of liquidity, so “Cash”, for instance, is the most liquid asset; “Short-term investments” are generally bank deposits which can be redeemed within 3-months and quickly converted to cash; “Accounts receivables” are IOUs from customers that promise payment; etc. etc. Remember, companies operate on cash. Just as in your personal lives, no number of IOUs is going to cut it when the bankruptcy police come around.
- Fixed assets, or non-current assets, are listed under current assets. These, while technically assets, are not things that you can readily sell for cash. Most tech. companies don’t have a lot of fixed assets. You will notice, however, that the entry for “Goodwill” accounts for a large portion of ATVI’s total assets. “Goodwill” is simply an accounting entry that gets logged anytime a company makes an acquisition of another company. Say I want to buy Company ABC, with its two chairs worth $15 each. The total book value of Company ABC is $30, but I’m willing to pay $40. The extra $10 would be logged as “Goodwill”. In ATVI’s case, the $7.2 billion in goodwill is the premium it paid for Blizzard.
- Liabilities indicate what the company owes. You’ll note that a software company like ATVI will generally not have any debt. This is a very good thing. Moreover, total liabilities for ATVI was only $3 billion, compared with the total current assets of $5.5 billion. For most companies, this means that if it ran into money problems in the future (games unable to be sold, etc.), it would still have a strong enough balance sheet that it could cover all its liabilities just from its current assets and still survive. Unfortunately, the value of tech. companies does not really derive from the book value of their assets, but rather, as mentioned earlier, their ability to generate earnings by staying ahead of the crowd.
Book value, by the way, is another way of saying “Total shareholders’ equity”, which is simply “= Total assets – Total liabilities”.
Income Statement
The income statement is also known as a “profit and loss statement” (P&L for short) or a “Consolidated Statement of Operations”, as it is known here. It provides a look, over the course of a specific period of time, of a company’s operating results.
ATVI’s income statement is pretty straightforward. As with all income statements, there are two essential parts: “Revenues” and “Costs and expenses”.
- ATVI has two revenue streams: they sell games, and they earn recurring revenue from their subscription services (World of Warcraft, etc.). In 2008, ATVI’s revenues jumped because of the merger with Blizzard.
- ATVI’s expenses, however, were greater than its total revenues. “Product costs”, presumably, especially the cost to make guitars for its Guitar Hero line, accounted for a huge proportion of expenses.
- “Operating income” is just “= Net revenues – Total costs and expenses” and it gives you an idea of how a company is internally performing.
- “Net income”, or in this case, “net loss” is also known as “profit” or “earnings”, and it factors in taxes and investment income which are generally not a significant portion.
Cash Flow Statements
Cash flow statements are similar to the income statement in that they provide a look at a period of operations, but they provide a more holistic picture of the company’s entire financial condition.
Cash flow statements are broken into three parts: “Cash flows from operating activities”, “Cash flows from investing activities”, and “Cash flows from financing activities.”
- Cash flows from operating activities starts with the net income, which is the same as the number on the income statement, and then adds back to it accounting charges which are made on the income statement, but which do not accurately reflect cash movements. “Depreciation and amortization” for instance, are recorded on the income statement (in ATVI’s case they’re not explicitly listed but they should be included in costs and expenses) as costs that get subtracted out of total revenues. However, no cash is actually exchanging hands, so the same amount needs to be added back to net income on the cash flow statement. The point to note is “Net cash provided by operating activities”, which is a similar concept to the income statement’s operating income. ATVI actually did generate positive cash flow internally in 2008.
[Note: Depreciation and amortization are accounting concepts which allow large purchases of property, plant, and equipment (PPE) to be expensed over a period of many years rather than a single period. The idea is that, when I buy a $10 million factory, I will be using that factory over a 20-year period, so it doesn’t make sense to book the entire cost of the factory in the year that I buy it. Rather, I should book the cost gradually as I use it—so every year I say that I’ve used $500,000 of its value—that $500,000 is the depreciation charge that goes on my income statement, which I don’t actually pay out cash for, and needs to be added back to net income in the cash flow statement.]
- Cash flows from investing activities include purchases of investments and also purchases of property, plant, and equipment—fixed assets which are necessary for the company to continue its operations. This is called “capital expenditures” or capex for short. Capex is very important to the understanding of the maintenance cost of a company.
- Cash flows from financing activities include raising money by issuing new shares, buying debt, or paying off old debts.
- “Net increase in cash and cash equivalents” represents the sum total of cash inflows and outflows at the end of the year. You’ll notice that most of the positive cash for ATVI came from its purchase of Blizzard and from selling new stocks—financial maneuvers rather than good operating results.
Conclusion
A company’s financial data should be read in accordance with the qualitative judgments the investor has already made. In this case, we made the qualitative assessment that this company ran based on the innovations and skill of its employees. Looking at the numbers, we can confirm this. The company has a very small amount of fixed assets in relation to the revenue it generates from them. While ATVI has a strong balance sheet position, its earnings feel a bit spotty with expenses and costs completely out of control. It is hard to say whether this is because of the merger with Blizzard or for other reasons. A prudent investor would dig deeper into the history of both Activision and Blizzard and see if any trends had changed since the merger. Significantly though, the investor can fairly definitively conclude that current trends indicate unpredictable results for the future.
RATIOS
Companies are obligated to report their financial data in terms of absolute numbers, but to make sense of the numbers, the interested observer has to see how they fit in relation to other numbers. Thus the need for a whole toolbox of financial ratios. Most of these ratios are calculated for you at Reuters Thomson financial data
P/E – Price to Earnings Ratio
P/E = Market Price / Net Income / Total number of shares outstanding
The P/E ratio gets slung around like a boozed up sorority girl but most people, I find, don’t actually understand what it suggests. The simple explanation is that the P/E is the cost, at the current market price, that the investor has to pay for $1 of a company’s earnings. So, if Company ABC makes $10 in profit this year, and its stock sells at $20, then the stock has a P/E of 2. Conversely, if I bought the stock at $50, it would mean that I was willing to pay $5 for $1 of the company’s earnings this year.
ATVI, which had negative earnings (a loss) in 2008, has no P/E ratio. You’d be paying it to lose money for you, is essentially what that P/E would mean.
ROE – Return on Equity
ROE = Net Income / Total shareholders’ equity
The ROE is a very important measure of management’s ability, and as close to a quantitative indicator of a company’s competitive advantage as possible. The ROE indicates how productive each $1 of equity (asset – liability) is. For most companies, an ROE that is greater than 12% (or $0.12 earned per $1.00 of equity) is considered quite nice, but you have to compare this to the industry average.
ATVI, again because it booked a loss in 2008, has a negative ROE, while the industry average was around 17%. It’s important to consider whether or not this is a one-time thing or symptomatic of something else. Improving ROE is a great thing in a company, as it suggest that management is getting better and better at handling its capital.
Margins – Gross margin, operating margin, profit/net margin
Gross margin = (Total revenues – Cost of goods) / Total revenues
Operating margin = Operating income / Total revenues
Net margin = Net income / Total revenues
Margins are pretty self explanatory. How much of your revenues are actually becoming profit, how much of it gets chipped away by expenses?
ATVI had a gross margin of 39%, which means that for $1.00 of revenue, only $0.61 was going to the cost of producing those revenues (raw material costs, etc.). However, operating expenses chip away most of the remaining $0.39 and by the time we come to operating margin ATVI is paying out $0.03 for each $1.00 it earns (operating margin of -3%).
Growth rates – Revenue growth, EPS growth, net income growth
Growth = ((Ending value – Starting value) ^ (1 / number of years)) - 1
The intelligent investor is not just looking for high growth, he’s looking for consistent, stable growth. Volatile growth is not interesting—not if it means a company might go from $5 million to $25 million to $1 million. The qualitative factors we looked at earlier will help an investor decide whether or not a company’s growth rates are relevant to its valuation.
ATVI’s numbers look great, a 170% increase in sales since a year ago—but remember, that’s because of the Blizzard merger, and not necessarily indicative of a consistent trend that we can bank on.
Conclusion
The information from ATVI’s financial ratios is difficult to read because of its negative earnings in 2008. A more conclusive picture could be drawn if we went back and dug up historical records. It is important to note, however, that negative earnings are almost never a good thing, especially when a merger was enacted specifically to grow earnings, not destroy them.
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PART 5: IDENTIFYING INTRINSIC VALUE – THREE COMPONENTS
As mentioned before, the first step to intelligent investing is determining intrinsic value. In this part of the guide we’re going to look at the three components of value that modern value-oriented investors should pay attention to, then, we’re going to bring everything together and try to determine an intrinsic value for Activision-Blizzard.
[Note: Be aware that “earnings” = “profits” = “net income” = “net earnings” = “net profits”; “sales” = “revenues” = “gross income” = “gross revenues” = “gross sales”]
ASSET VALUE (AV)
Theory
This is the type of value that Ben Graham looked at. Asset value is, unsurprisingly, the value of the assets which a company owns. There are two takes on asset value, liquidating value and replacement/reproduction value.
Liquidating value is the simpler concept. It’s the idea that a company is valued at whatever its component parts can be sold for. In the example of John and Joan’s Company ABC, the assets of the company are the two chairs that Company ABC possesses. The liquidating value of the company is the total price that those two chairs can be sold at. Almost all companies sell at a premium to their liquidating value, however, simply because the market is willing to recognize that a company isn’t simply the sum of its component assets. The only time liquidating value is very important is when a company is on the brink of bankruptcy and it might actually be
The replacement value of a company doesn’t look at a company in terms of how much it would fetch if it had to be torn down and sold immediately. It looks at how much it would cost a competitor to reproduce the exact same business. In a sense, we want to know how much the assets of the company are worth with the company alive, rather than dead.
Numbers
A decent approximation of a company’s asset value is the company’s total equity or total shareholder’s equity or shareholder’s equity or book value, which is stated explicitly on a company’s balance sheet. The book value is just total assets minus total liabilities (debts, loans that need to be paid off, etc.). However, sophisticated investors usually make significant adjustments to the values of the stated assets for their purposes.
Liquidating value, for instance, is only concerned with the most tangible of a company’s assets. Most companies have cash, inventories, and other “current assets”—assets which are easily and readily convertible to cash. Most companies also have “non-current assets” like factories, equipment, machinery, and the such which are listed at a value on the company’s balance sheet which may overstate how much they would actually fetch in a fire-sale. In assessing replacement value, there are also times when the value on the company’s books might understate the reproduction value of the company’s assets. Either way, the art is in the investor’s ability to assess a more accurate picture of what the company’s assets are worth, in total.
EARNINGS POWER VALUE (EPV)
Theory
Asset value is the most tangible way to think of a company’s intrinsic value but oftentimes it understates what a company is truly worth. Most companies are not just the sum of their parts; they perform some task which creates value on top of the cost of their assets. They might be turning corn into corn flakes, for instance. Or, in the case of Company ABC, they are renting out chairs; which adds value by making chairs available when people need them rather than stored away and unused. Either way, this additional value can be captured by looking at a companies earnings—the profits that they can generate over and above their expenses.
The earnings power value of a company can be thought of in this way: imagine if you had a box which could print $100 and then it would poof, magically disappear (the box; you keep the money), how much would this box be worth? The answer is $100. If this box could print $100 today, then it would wait a year before it printed another $100, then it would disappear, how much would the box be worth? The answer is: slightly less than $200.
[Note: There’s a very important reason why it’s not precisely $200—the time value of money. Think about it this way, would you rather have $100 now or $100 in a year from now? If you said it doesn’t matter, then you’re forgetting that you could potentially put your $100 now in a savings account, in an index fund, in a treasury bond, or any number of other investments which would earn you a risk-free amount of interest. Generally the long-term Treasury bond is considered a risk-free rate, and that earns about 10% a year, meaning that $100 now is worth at least $110 in a year from now. Conversely, $100 a year from now, discounted by the 10% interest rate would give it a present value of only about $91. (PV = FV/(1+r)^n; where r = interest rate and n = number of years)]
So you want to think of a company in the same way. How much are all the future earnings of a company going to be worth, discounted to their present value? In other words, how much are the company’s future profits worth to me today?
Numbers
With earnings power value, we are assuming a consistent rate of earnings for the company year after year after year. So all we need to do to determine an intrinsic value is to project a future earnings figure and divide that by an appropriate discount rate: EPV = Future Earnings / Discount rate.
Thus, a black box like the one we postulated earlier that would never disappear an.d would continue to print $100 bills every year, year after year after year, would be worth $100/10% = $1,000 based on a 10% discount rate. You can use this method on a company which has very consistent earnings and which you believe will continue to have very consistent earnings. So, for instance, a company like Target with fairly stable earnings of $2 billion a year might be fairly valued at about $20 billion (right now it’s selling at about $30 billion).
Notice how large a difference a 5% change in discount rate would be: $2 billion/10% = $20 billion vs. $2 billion/5% = $40 billion. This is why asset value is much more conservative, and also why, inevitably, you’re still guessing at numbers. This is also why the margin of safety is important, so even if you overshoot, you still have a margin of error.
GROWTH
Theory
Growth is the least tangible and therefore least trusted component in value. Determining asset value requires some tweaking of the assets that currently exist within a company. Determining EPV requires some guesses at what the company might reliably sustain. Determining growth requires, even further, guesses at how the company might change and improve in the next couple of years. For that reason, many value-oriented investors shy away from talking about growth at all, as they simply feel uncomfortable trying to guess at the future. Nonetheless, to ignore it would overlook many great investing opportunities.
Numbers
As mentioned before, growth is simply a component in determining value. But it’s a very important component as it can drastically affect the numbers your black box company spits out. The problem is still the same though--you want to find what all future earnings from the company are worth to you now. To solve this problem requires a discounted cash flow (DCF for short). The following depicts what a DCF looks like. Again we use our infinite, $100-spitting black box again, but this time, we assume that every year, the amount that it spits out grows by 15% until the 5th year, after which the amount will slow down to a steady growth of 4% per year.
1) The growth rate, discount rate, and long-term growth rate are inputs into our model. So is the $100 we have already seen the black box spit out this year.
2) Now, to project future earnings, in our first row, we calculate 100 x 115% for year 1, that number x 115% for year 2, and so on.
3) In the second row, we discount those future values by the discount rate using our PV = FV / (1+r)^n formula.
4) In the third row we simply sum up the present values of the cash payments from the black box for the first 5 years. If the black box disappeared at this point, this is how much it would be worth.
5) But since it continues to exist, albeit at a lower rate of growth, we have to calculate what is known as a residual or terminal value, which is the present value of all future earnings from the black box, from Y6 until infinity.
6) Add the present value of the earnings from Y1 to Y5 and the present value of the earnings from Y6 until infinity and we arrive, finally, at our intrinsic value.
This is a standard two-stage discounted cash flow, and it generally models how most growth companies can be thought of—a period of fast growth early on, and gradually slowing down to a slower long-term growth rate. As we can see, at a short-term growth rate of 15% and long-term growth rate of 4%, our black box is now worth $3,170, compared with the $1,000 we said it was worth if it only returned $100 a year. The difference, obviously, is huge.
INTRINSIC VALUE
All three of the listed valuation methods above are component parts to help the investor gain a better understanding of a company. Certain companies are better valued using different components, and the investor should realize the relevance of each component towards assessing the intrinsic value of a particular company.
ATVI, for instance, is not an asset-driven company. It does not require a large amount of fixed assets to manufacture its product. ATVI relies more on the earnings power generated by its employees and its brands. However, ATVI is not a consistent earner—the strength of the company is its potential for future growth. If we want to get a rough idea of what ATVI is worth then, we would have to do a discounted cash flow analysis.
DISCLAIMER: Very important is the fact that as an intelligent investor, and having assessed ATVI both qualitatively and quantitatively, I would come to the conclusion that this is not a company that I could accurately project future growth rates for. I WOULD NOT run a DCF analysis on this company; I would not attempt to project its future potential; I would not attempt to guess at its intrinsic value; and I would not try to invest in ATVI. There are investors who wouldn’t shy away from the challenge, who might possess more information than I do, who might, with that information, be able to reliably predict future operational results for ATVI, but I cannot make that claim, and I would not, nor any other intelligent investor in my position, move forward on the basis of what I do know.
For the sake of those curious and interested, however, I will demonstrate what a full-blown DCF might entail.
The grayed areas are the variables which the investor is responsible for inputting. Changes in these assumptions can cause huge differences in the guesstimated fair/intrinsic value. I project revenues based on what I believe future growth rates may look like for the two separate revenue streams, then I project future expenses based on the percentage of revenue they have accounted for in the past.
Remember, though, that this is just a proof of concept, and simply to illustrate a potential scenario for ATVI. If it can grow net income at an annual 9.5%, it might be worth $14 today. However, the investor should always remember to factor in a margin of safety of at least 33%--taking it down to $9 (a projection like ATVI’s would probably be better off with an even greater margin of safety: 50-75%).
FOLLOW-UP
If this was a reliable projection, I’d say that the next step would be to go out, compare it with the current market price, and then make a quick mechanical decision. The problem is, I don’t trust the projection, and nor should you. However, fundamentals change, and it’s quite possible that in the near future ATVI might turn around and develop a stronger, more sustainable business. In that case, the investor would be well-advised to take a look at it again as if it were a new company and reassess it from that standpoint.
Hypothetically, if the investor trusted his projection and bought into a company with a significant margin of safety, that investor should rest easy at night and not be concerned with the day to day schizophrenia of the market. Fundamental changes are important, new financial results, company-related news—these may all signal a change in the assumptions that the investor used to determine the company’s intrinsic value. But until then, the intelligent investor should trust in his analysis and stay firm in his convictions.
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PART 6: ADDITIONAL RESOURCES
GLOSSARY
Asset class – Stocks, bonds, real estate, currencies, commodities, funds are all examples of different asset classes.
Asset manager – Also known as a money manager, investment manager, portfolio manager, or fund manager (there are slight differences but it’s not really important). Asset managers may be hedge fund managers, mutual fund managers, or any other type of manager who handles other people’s money for a living. Asset managers, known as the buy-side, look down on investment bankers as middlemen and beggars.
Bear market – A market where pessimism and fear reign supreme. Prices generally fall as investors try to rush out of the market and go into other asset classes. For the value-oriented investor, bear markets generally present great buying opportunities as securities become mispriced on the low side (undervaluation).
Book value – The value of a company as stated on its balance sheet. Otherwise known as shareholders’ equity = total assets – total liabilities.
Bull market – A market where optimism and greed reign supreme. Prices rise as investors flood into the market with barrels of borrowed money. For the value-oriented investor, bull markets are generally times to sell (as prices rise to intrinsic value) or times to sit out completely, while the investor waits for more sensible prices.
Circle of competence – Peter Lynch encouraged investors to buy what they knew. Buffett worded it differently as staying within your circle of competence.
Closed-end fund – Professionally managed pools of money similar to a mutual fund, except they only issue a finite number of shares. Investors are locked in for an agreed upon period of time. Thus, the net asset value of a closed-end fund will only be affected by internal results, and not by the movement in or out of investors.
Competitive advantage, aka moat – A business advantage that is difficult for a competitor to replicate.
Debt – To be thought of in contrast with equity. Debt entitles the holder (the person who gives the loan) to a fixed income stream (interest) and the return of principal (the original amount loaned) but not to any ownership rights in current or future earnings. Debt is generally considered less risky, but also less rewarding.
Dividend – When companies earn profits, they can either reinvest the money into their operations or return the money to the shareholders of the company. If the money is returned to the owners, it is called a dividend.
Equity – Another way of saying shares of stock that give ownership rights to the holder. Equity can also be thought of in contrast to debt. Equity gives the holder rights to all current assets and future earnings of a company, whereas debt only entitles the holder to a fixed income stream (interest) and the return of principal (the original amount loaned).
Exchange-traded fund – The confused and bastard child of a closed-end fund and a mutual fund. Like mutual funds, investors hold a proportionate interest in the assets that the fund owns, but unlike mutual funds, ETFs can be traded at any time during the day, rather than only at the end of the trading day).
Hedge fund – Investment pools that are largely unregulated. Originally the term was derived from the “hedging” strategy most funds would take, but nowadays it’s pretty much just synonymous with any fund that does whatever it wants (as opposed to the more regulated mutual funds, closed-end funds, etc.)
Index fund – A basket fund that attempts to mimic the performance of a market index or benchmark. An S&P 500 index, for instance, would buy all the shares in the same weight of the companies that constitute the S&P 500.
Inflation – The tendency for prices to rise over time, and for purchasing power to decrease. Because of inflation, a nominal amount of cash today will be unable to buy as much in the future as it can now.
Intrinsic value – The underlying value of a business, separate from what the market and popular opinion considers it to be worth.
Investment banker – The idea of a banker is simply someone who can provide cash to an individual when he needs it. The investment banker does the same thing but for companies. Investment bankers help to secure debt or equity financing for companies by arranging deals with other companies and banks, or by selling the companies debt obligations or equity shares. Investment banks are the central financial institution in any established capitalist society. If a company needs money, needs to do a deal, or just needs a shoulder to cry on, they’ll call their investment banker before they call their mothers. Investment bankers, known as the sell-side, consider asset managers pompous but are secretly jealous.
Liquidation – The event in which a company shuts down, sells all its assets, and pays off the people it owes.
Margin of safety – Benjamin Graham preached the idea of giving yourself room for error by using a margin of safety. Arithmetically, the margin of safety was used to deduct anywhere from 33% to 50% off of an intrinsic value calculation.
Mutual fund, aka open-end fund – Professionally managed pools of money. The thing that really sets a mutual fund apart is the fact that investors can buy in or sell out of the fund at any (or almost any) time. The net asset value of a mutual fund, then, can change depending on whether investors enter or exit the fund. Mutual funds are fairly well regulated.
Wall Street – A mythical fairytale world where cash spews from water fountains and gold bullions are flattened and used as tissue paper. Wall Street is where most of the investment banks in the US are headquartered, and thus the financial center of the world.
KEY PEOPLE
Warren Buffett – Super famous, super successful investor. Aristotle to Ben Graham’s Plato. Buffett is one of Graham’s direct disciples. He built upon Graham’s principles and developed them into the winning formula of the second richest man on the planet.
Benjamin Graham - Father of all that is holy in investing. First to really develop a framework by which to approach investing as a science or craft.
Eddie Lampert – One of the two younger guys here (along with Pabrai)--and by younger I mean 40 something as opposed to 60+. Sometimes called the king of the hedge funds, sometimes known as the imitation Warren Buffett. Now the Chairman of Sears Holdings after merging Sears with Kmart. Runs his hedge fund with a large degree of concentration, like Buffett. At one point Forbes estimated his one-year take-home as ~$2 billion.
Peter Lynch – Legendary manager of Fidelity’s Magellan fund. Ran it for 13 years, achieved compound annual return of 29% -- 29% each year, every year, for 13 years. $1,000 originally invested would become $27,000. While not a direct student of either Graham or Buffett, Lynch practiced a very similar style but with a bigger emphasis on growth.
John Neff – Another old fart. Well-recognized as a cheap, cheap investor. Focused on low P/E stocks. Could be considered prototypical value investor.
Mohnish Pabrai – Runs a hedge fund in California. Employs a Buffett-esque hedge fund structure (money from friends and family, no performance fee) and returns Buffett-esque numbers: ~29% over the 10 or so years he’s been managing.
John Templeton – Famous contrarian investor, meaning he was devoted to the idea of buying when others sold and selling when others bought. Also one of the first to look for opportunities internationally. His flagship fund returned 13.8% from 1954 to 2004 compared with the S&P’s 11.1%. That doesn’t seem like a lot but over 50 years, $1,000 with Templeton would equal $641,000 whereas $1,000 with the S&P would only be $193,000.
BOOKS
The Intelligent Investor – Benjamin Graham
Value investing: From Graham to Buffett and Beyond – Bruce Greenwald
The Warren Buffett Way – Robert Hagstrom
Select Winning Stocks Using Financial Statements – Richard Loth
Beating the Street – Peter Lynch
John Neff on Investing – John Neff
The Dhando Investor – Mohnish Pabrai
Portfolio Management - Robert Swenson
INTERNET RESOURCES
Investopedia – Wikipedia for the financial crowd. One of the best references online.
Warren Buffett resources - Buffett-related articles.
The Superinvestors of Graham and Doddsville – One of the most important essays written about value-oriented investing. Buffett delivered this speech to satirize the EMH and its prediction that an investor would be better off picking stocks at random than employing any analytical techniques. VERY RECOMMENDED.
Value investing resources - Vast collection of articles and essays. Has links to Buffett’s partnership letters and his letters to shareholders at Berkshire Hathaway–the only texts Buffett has ever written about investing. Very good as well.
STOCK SCREENERS
Google stock screener - Highly customizable. Doesn’t do everything I want it to but comes close.
Morningstar stock screener - One of the few screens that includes PEG ratio.
INVESTING SIMULATORS
Investopedia Stock Simulator – Start with $100,000 virtual cash and build up your portfolio.
The Motley Fool - CAPS - Make stock picks, earn points based on your performance.
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DISCLAIMER
In response to some of the questions and criticisms I've been seeing in this thread, I felt maybe it'd be prudent to include this statement here:
I've been involved in the investment industry for more than a few years now. I worked at an international investment bank for a while, doing the standard--investment analysis, deal sourcing and structuring for hedgies and other IB boys--and then moved on to the buy-side. I don't consider myself a guru in this field, I'm still learning along with everyone else here. I wrote this guide because I thought it would be interesting to see if I could help someone with zero financial knowledge and walk them all the way through an entire investment analysis.
I fully admit I referenced Wikipedia, Investopedia, Google, Thesaurus.com, Dictionary.com, and probably a lot of other resources in compiling this guide. I think it's prudent to check your facts, no matter how sure you are of them. However, every word was typed from my hand, and where it was not, the phrase will be in quotation marks to make clear that the words are not my own.
I welcome criticism, but I hope that in the spirit of completeness and fairness, that the critics put at least a shadow of effort into their remarks. Please specify where my errors are and perhaps a suggestion for how it can be improved!
ACKNOWLEDGMENTS
I just wanted to thank everybody in advance for their interest, and TL.net for being such a great community.
Please feel free to ask any questions in the thread, I will attempt to answer as best I can. I also welcome PMs if people feel more comfortable that way.
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United States20661 Posts
It's an easy-to-read, informative introduction to investing so far :x Nothing groundbreaking, but it looks sound.
Looking forward to the rest of the guide!
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Nice someone posted before me, now I can post without fearing that I am breaking into possible reserved space :p
Skimmed through it and like LR said, looks informative if not groundbreaking, but it is exactly what a lot of people here need anyway. I too am looking forward to this guide's completion.
EDIT - Now that I am actually reading it I am feeling a sense of deja vu, I suppose that's good news.
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today for my birthday my mom took me to open an account for schwab and told me to get a job.
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Great guide. Usually, I just read and lurk, but this was informative.
On June 06 2009 17:02 DeathSpank wrote:
today for my birthday my mom took me to open an account for schwab and told me to get a job.
Why post this trash in a good guide you disgusting maggot. Your mother is right to get you off her financial nuts.
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On June 06 2009 17:07 kdog3683 wrote:Great guide. Usually, I just read and lurk, but this was informative. Show nested quote +On June 06 2009 17:02 DeathSpank wrote:
today for my birthday my mom took me to open an account for schwab and told me to get a job. Why post this trash in a good guide you disgusting maggot. Your mother is right to get you off her financial nuts.
=D
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Your assessment of hedge funds, fund of funds, ETFs, etc is extremely biased. It's frequent practice for the manager/CIO of a hedge fund to invest his own capital into the fund that he's running. Even if this were not the case, there's plenty incentive (read millions of dollars) for managers to try to "beat the market." If I'm a multimillionaire, and not extremely risk averse, hedge funds may be a smart investment given some research.
Just as a note; the hedge fund industry in general is up about 9% YTD.
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This was a really good topic to make a guide on and it seems you put a lot of effort into it. I find that with the other guides, it's either they're based on common sense themes or things you can easily read about on the net. I haven't read the guide yet but based on skimming it, I'm looking forward to it.
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I found this easy to read and very informative. You put a lot of effort into this guide, can't wait to see the rest of it.
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3861 Posts
Wow - this is really really good guide, thanks for your efforts and can't wait to read the rest of it!
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This is a great guide, I'm going to bookmark this 
I'm a complete noob when it comes to financing, the stork market, invested, etc, so this helps me out a lot.
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heavily copy-pasted, but still a good collection
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great work, very informative...looking forward to the rest of it
AND
...i might just have to bookmark this
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