Phase I - Four Core Principles of Value Investing Archives | Value Investing

Value Investing – Churning (Lesson 18)

Phase I - Four Core Principles of Value Investing, Lessons/Tutorials/Resources / By David J Hoare MSA / 01/08/2022

Churning refers to agitating. It is commonly used with the dairy industry to refer to the process of turning liquid cream into butter. The churning process breaks down the fat membranes allowing the fats to join together. In effect, churning means to work the liquid into a solid. With investing, churning has two different connotations. The first is the more common negative connection to brokers getting their clients to buy and sell frequently in order to increase overall commissions for the brokerage. The positive connotation is rarely used and it refers to working one’s portfolio of investments to maximize overall return. That is what this lesson is about. How does a value investor work their portfolio to maximize overall portfolio return?

The ideal method to maximize return is buying low and selling high at the right time with investments that have quick recovery time frames. Ideally, all the cash proceeds from a sale should be immediately reinvested into new opportunities. Often, this is not the case. When the respective markets such as the DOW, S&P 500 or the S&P Composite 1500 experience highs, it is difficult to find good quality investments at low prices. This is further hampered when a value investment fund has limited options. In order to provide ample opportunities for reinvestment of cash, value investment funds require at least five pools of industries and a minimum of 40 stocks. The ideal fund will have around eight pools of potential investments with no less than 60 potential securities.

Value Investing – Monitoring Performance (Lesson 17)

Phase I - Four Core Principles of Value Investing, Lessons/Tutorials/Resources / By David J Hoare MSA / 03/25/2021

Monitoring performance is the single best tool to ensure success with value investing. Comparing results against expectations provides the basis for good decisions. In business, this is known as the feedback loop. In effect, a variable input is changed, results are recorded, compiled and reported in a understandable format. Any unexpected results are analyzed and input changes are implemented. The pattern is repeated. The end goal is to generate continuous improvement. With business, improvement is stated in the form of profit; with investment funds, it is stated in the form of percentage of return on the overall invested capital. Thus, managing an investment fund is just like operating a business; the goal is to improve overall performance.

Throughout this series of lessons in Phase One of the program, it has been stated and reiterated several times. The goal of value investing is to generate returns that far exceed the returns of several indices. A value investor should expect at least a return on their investment in the mid-twenties as a percentage per year. The real goal is to generate 30% plus with returns. If the investor does their research properly and adheres to the four principles of value investing, achieving 30% plus per year on average is doable. But without monitoring performance of the fund, an investor cannot make the necessary timely adjustments to achieve the annual goal.

Value Investing – Setting Buy and Sell Points (Lesson 16)

Phase I - Four Core Principles of Value Investing, Lessons/Tutorials/Resources / By David J Hoare MSA / 02/18/2021

Setting buy and sell points for any investment security determines the investment’s final return. If the buy is made too early while the security is falling in price, the value investor loses out on not only additional margin upon the sale of that security, but also reduces their margin of safety associated with the intrinsic value point. It is similar on the other side of intrinsic value. If sold too soon, the value investor leaves money on the table. Thus, setting the buy and sell points are important decisions for every investment.

There are tools available to determine these two values. In the simplest of statements, the easiest rule to follow is the Pareto Principle, the old 80/20 rule. This rule basically states that roughly 80% of all outcomes are within 20% of of the value. With security pricing, this principle is simply that 80% of the value change will occur within 20% of the starting point. Thus, if a security’s intrinsic value is $80, then the probability is that 80% of the maximum change in value will happen within 20% points of the price shift. Therefore, the buy is approximately $64 and the sell point is $96. Almost certainly, this rule isn’t pure with security investing. The conception is that if the end results are beyond this 20 percent under and over the intrinsic value point, the value investor must have additional financial support and a lot of history with the security to validate expanding the buy and sell points beyond 20% fluctuation.

This lesson first introduces a basic model to illustrate and reinforce setting the respective buy and sell points. This model emphasizes an important aspect of price change. The angle of change affects the return on the investment. The steeper the price change, the shorter the time period for the change. The shorter the holding period for any investment, the greater the return on the investment. This is illustrated with a chart in this section of the lesson.

Value Investing – Investment Fund (Lesson 15)

Phase I - Four Core Principles of Value Investing, Lessons/Tutorials/Resources / By David J Hoare MSA / 01/29/2021

An investment fund is a collection of capital from one or more individuals and is used to purchase financial instruments of various companies or other funds. The most common types are brokerage funds that allow incremental purchases from members. These funds are often dedicated to a certain group or type of investment. These groups or types of investments have a set of similar attributes. Some funds are dedicated to stocks from only small-cap companies. Other funds focus on a sector or industry within the economy. For example, there are utility funds, real estate funds and retail based funds.

The primary goal of a fund is to restrict the purchases of financial instruments to a certain investment group or type believing that this group or type is dynamic enough to earn a good return for its members that contribute the capital to buy rights to companies.

There are two forms of investment funds. The first form is an open fund. This means that it continuously allows new investors into the fund and its capital basis can expand over time. Most brokerage funds are open as they are used with many retirement plans. The opposite of this is a closed fund. Here, a preset sum is invested and the fund grows off this limited capital investment. Ownership of the fund may change as a member has the right to sell their respective position in this fund.

When a value investor creates their fund, they utilize pools of similar investments in their fund to enhance the fund’s overall performance. It is encouraged to have at least three pools of investments in a fund and no more than six pools. A well designed fund uses the attributes of the respective pools to reduce risk, improve overall performance and minimize the holding of cash. The following three sections cover these three pooling benefits and how they achieve the overall goal of value investing.

Value Investing – Pools of Investments (Lesson 14)

Phase I - Four Core Principles of Value Investing, Lessons/Tutorials/Resources / By David J Hoare MSA / 01/22/2021

Value investors utilize pools of similar companies all belonging to the same industry in order to reduce risk, create accurate buy/sell models and manage their portfolio of investments in their investment fund. It is essential that all potential investments in a pool have similar attributes including market capitalization, comparable operations, indistinguishable balance sheet relationships and reporting formats. As explained in Lesson 11, all the members of the pool should have similar key performance indicators.

It is impossible to single handily manage hundreds of potential investments and design/build a separate buy/sell model for each company. To simply and efficiently create an investment portfolio, value investors create a group of five to eight very similar companies in the same industry. This is referred to as a ‘Pool’. Since this pool is dedicated to a particular industry, the investor can appreciate the research and due diligence required to understand the industry’s terminology, operational standards and performance outcomes. It is the most efficient use of time.

Most value investors can only manage one or two pools of similar companies. However, one or two pools is insufficient to maximize a value investment portfolio. Thus, it is best to turn to a club whereby several pools are available to the investor. In effect, all club members share the knowledge of their own respective pool with other club members and this diversifies the portfolio for all members. When an opportunity arises, all members are alerted and the club is rewarded as all members benefit from participation.

This lesson explains the benefits of using pools of similar potential investments as a value investor. Pools reduce risk exposure due to the comprehensive understanding of the key performance indicators and industry standards learned from research work and review of multiple similar reports. Secondly, with this knowledge, value investors can create highly accurate intrinsic and market price models to set the buy/sell points for investment with each member of the pool. Another advantage pools of investments create is the ability to efficiently utilize time to update the models. This in turn, allows the investor to focus on properly carrying out the systematic buying and selling of stock to generate excellent returns.

Value Investing – Industry Standards (Lesson 13)

Phase I - Four Core Principles of Value Investing, Lessons/Tutorials/Resources / By David J Hoare MSA / 01/03/2021

Have you ever wondered how the measurement of length called a ‘meter’ came to be? It is simply the distance light travels in a given time period. The key isn’t the actual definition, it is whom dictates this time period of travel. Some authority states that this is the definition of a meter (also written as ‘metre’). It is currently the International Committee for Weights and Measures based out of France. It is an 18 person task group promoting uniformity with units of measurement. This committee is the authority.

This same principle of authority exists in business. Every industry has their own authority or set of principles promulgated by an agreed upon group of individuals or a leader within that group. For value investors, understanding the authority for the respective industries is essential to measuring success for each member company within the pool of potential investments. Once a value investor recognizes what is the standard of production or performance, it becomes easy to compare their respective investments and then equate this into financial value. There is a hierarchy of authority for all industries. In almost all cases, the number one authority is a governmental institution or law. Other levels of authority at the next level include academia, associations, journals, books, white papers and committees. The third level of authority include experts and company level affiliations. The final level of authority is the leader in the respective industry.

Each of the following sections explore these different levels of authority. In each section, there is an introduction to the various resources the value investor may wish to use when investigating their respective industry. The key to this lesson is to understand that higher levels of authority are the standard setters. Value investing is about having facts to support a buy/sell position with each member of the pool of investments. The stronger the authoritative position of the standard setter, the more accurate the buy/sell trigger points can be calculated.

Value Investing – Business Ratios (Lesson 12)

Phase I - Four Core Principles of Value Investing, Lessons/Tutorials/Resources / By David J Hoare MSA / 12/31/2020

Business ratios are used to compare similar companies within the same industry. RULE #1: DO NOT USE BUSINESS RATIOS TO COMPARE COMPANIES AGAINST EACH OTHER IF THEY ARE IN DIFFERENT INDUSTRIES.

Business ratios are not perfect, they have their respective flaws and it is important for value investors to understand the algorithms used with business ratios. It is also important to note that business ratios can be easily manipulated and result in misleading outcomes. More importantly, business ratios only reflect current information and not long-term trends. Think of business ratios as comparable to a doctor acquiring your vitals upon your medical visit. The vitals only reflect the ‘then and now’ status of your medical condition. They do not reflect your lifetime nor trending condition.

In effect, business ratios have a purpose, although limited. They are the best tools to compare similar companies within the same industry and typically the same market capitalization tier. Thus, a second rule to use with rule number one above; RULE #2: USE BUSINESS RATIOS TO COMPARE SIMILAR MARKET CAPITALIZATION COMPANIES WITHIN THE SAME INDUSTRY.

Because business ratios can be easily manipulated, it is important that users of business ratios have a full understanding of their respective formulas. RULE #3: BUSINESS RATIOS ARE NOT AN ABSOLUTE RESULT. They are merely indicators and that is all they are good for when interpreting their results.

Even with the above limitations, business ratios are beneficial to investors as they are the best method of comparing existing or potential investments. Their results are not perfect, but they can indeed provide adequate confidence when making pertinent decisions about a companies current financial status.

Value Investing – Key Performance Indicators (Lesson 11)

Phase I - Four Core Principles of Value Investing, Lessons/Tutorials/Resources / By David J Hoare MSA / 12/29/2020

All of us use indicators everyday to help us manage our lives. These indicators assist us with making good decisions. This same concept exists with stock investments. There are several different indicators related to stock. Most of them are financial in nature and often summed up via business ratios. However, many of the top companies provide additional indicators. One of these additional groups of indicators are ‘key performance’ markers. In effect, they are production based bits of information that assist value investors in developing and validating a good buy/sell model for that particular company.

Performance indicators are different for each industry. For the value investor, understanding the respective industry along with their systems, processes and critical points are essential when evaluating the current stock price along with market reactions. It is important for the value investor to understand not only the quantitative results of performance, but the standard of performance to measure the actual outcome against. In most cases, performance indicators exist with sales, production, and marketing/advertising. The key to success is to incorporate all these different data points and create an impact factor with the company’s stock price.

The end goal of monitoring performance is to determine if the buy/sell model requires any update. It is a simple ‘Yes’ or ‘No’ decision. When creating a trend line of data, it is best to look at as much history as possible, the author suggests no less than five years; preferably the trend line should be greater than seven years. Analytical standards place more emphasis on recent outcomes in comparison against the more historical results. Value investors take a more conservative approach and use the average of the trend line to determine the ‘Yes’ or ‘No’ model update. The reasoning is simple, short-term results or near-term expectations should have little bearing on overall historical performance and the corresponding buy and sell triggers for a particular stock. Just because the recent performance is either elevated or depressed doesn’t indicate an ongoing trend. Recent performance may have been hampered or enhanced due to environmental or unusual conditions. Basing one’s decision on the most recent results is speculative and not a sound investment concept. Using the overall average is superior as it eliminates speculation.

Value Investing – Financial Statements (Lesson 10)

Phase I - Four Core Principles of Value Investing, Lessons/Tutorials/Resources / By David J Hoare MSA / 12/16/2020

To comprehend financial information, first the member must understand their general purpose and how they are prepared. The first section of this lesson introduces financial statements and their two primary purposes. In addition, pertinent issues are introduced that a company must endure to finally present a well prepared set of reports. Next, each of the five major types of financial statements are introduced. Most companies present a core set of five that include a 1) balance sheet, 2) income statement, 3) cash flows statement, 4) statement of retained earnings, and 5) a set of notes to clarify the four other statements. Some go further and present industry and highly customized financial reports. These are covered in Phase Two of this program along with the Pool’s information center that members have access to on this website. Finally, this lesson covers the importance of a few key bits of information and how these critical financial values impact the respective buy/sell models value investors develop.

Many stock market investors are not familiar with financial reports; they rely on accountants to provide the results in laymen’s terms in order to make decisions. This program is designed to build the confidence of non-accountant types to not only understand financial reports but to appreciate and ultimately, eagerly await their arrival each quarter. Again, Phase Two of this program goes in-depth about financial statements and how to interpret the information.

This lesson utilizes the financial reports as presented for the year 2019 from the Coca-Cola company. Coke is a DOW company and is considered one of the best stocks to own if you can purchase the stock at a good price. Coke is a dividend based purchase and often buyers purchase Coca-Cola stock to hold and receive dividends.

Value Investing – Principle #4: Patience (Lesson 9)

Phase I - Four Core Principles of Value Investing, Lessons/Tutorials/Resources / By David J Hoare MSA / 12/12/2020

This lesson isn’t about emphasizing patience, it is about understanding how patience actually creates financial wealth in the market. Unlike day trading which is not much more than gambling, value investing is about earning good returns on one’s investment. The decision models built will never create instantaneous wealth, they are simply designed to take advantage of a good portion of the market price extremes that stocks experience. The first part of this lesson introduces the reader to certain terms used with cycles. It explores cycles with two areas of nature, sound and ocean waves. The next part of this lesson explains how the market as a whole experiences ups and downs just like wave patterns. These cycles, just like sound and ocean waves have a reasonable correlation to predictability. The next section takes this cycling effect into the industry level of the market. What is commonly called the ‘Pool’ of investments with value investing. This cycling of value continues into the respective investments. These first four sections introduce the overall concept of cycling with stock prices.

With the concept of cycling, this lesson then introduces how a value investor captures maximum return on an investment by smartly setting the respective buy and sell points. There are some drawbacks to this concept, if the cycle is extended, the overall return on the investment decreases. This is covered in the fifth section below. What is really important to remember is that even though there may be an extended cycle period, it doesn’t mean the value investor lost money; it just simply means the overall return on the investment fund will be less than anticipated. Thus, in some years, your fund may experience only 10% overall growth whereas in some other years, it may experience 35 to 40% growth. The key is the long-term approach to value investing. What accumulates wealth is patience, a lifetime of patience.

Phase I – Four Core Principles of Value Investing