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by
Pat Dorsey
Read between
August 28 - September 25, 2021
Here are the five rules that we recommend: 1. Do your homework. 2. Find economic moats. 3. Have a margin of safety. 4. Hold for the long haul. 5. Know when to sell.
Five rules of investing by pat dorsey
The key to identifying wide economic moats can be found in the answer to a deceptively simple question: How does a company manage to keep competitors at bay and earn consistently fat profits?
The size of your margin of safety should be larger for shakier firms with uncertain futures and smaller for solid firms with reasonably predictable earnings.
Before I discuss when you should sell a stock, I ought to point out when you shouldn’t sell. The Stock Has Dropped
The Stock Has Skyrocketed
So when should you sell? Run through these five questions whenever you think about selling a stock, and you’ll be in good shape. Did You Make a Mistake?
Have the Fundamentals Deteriorated?
Has the Stock Risen Too Far above Its Intrinsic Value?
Is There Something Better You Can Do with the Money?
Do You Have Too Much Money in One Stock?
seven easily avoidable mistakes that many investors frequently make. Resisting these temptations is the first step to reaching your financial goals:
1. Swinging for the fences 2. Believing that it’s different this time 3. Falling in love with products 4. Panicking when the market is down 5. Trying to time the market 6. Ignoring valuation 7. Relying on earnings for the whole story
The four most expensive words on Wall Street are “It’s different this time.” History does repeat itself, bubbles do burst, and not knowing market history is a major handicap.
the reality is that great products do not necessarily translate into great profits.
When you look at a stock, ask yourself, “Is this an attractive business? Would I buy the whole company if I could?” If the answer is no, give the stock a pass—no matter how much you might like the firm’s products.
You’ll do better as an investor if you think for yourself and seek out bargains in parts of the market that everyone else has forsaken, rather than buying the flavor of the month in the financial press.
The only reason you should ever buy a stock is that you think the business is worth more than it’s selling for—not because you think a greater fool will pay more for the shares a few months down the road.
If operating cash flows stagnate or shrink even as earnings grow, it’s likely that something is rotten.
To analyze a company’s economic moat, follow these four steps: 1. Evaluate the firm’s historical profitability. Has the firm been able to generate a solid return on its assets and on shareholders’ equity? This is the true litmus test of whether a firm has built an economic moat around itself. 2. If the firm has solid returns on capital and consistent profitability, assess the sources of the firm’s profits. Why is the company able to keep competitors at bay? What keeps competitors from stealing its profits? 3. Estimate how long a firm will be able to hold off competitors, which is the company’s
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free cash flow—which is simply cash flow from operations minus capital expenditures.
Next, divide free cash flow by sales (or revenues), which tells you what proportion of each dollar in revenue the firm is able to convert into excess profits.
Strong free cash flow is an excellent sign that a firm has an economic moat.
In general, firms that can post net margins above 15 percent are doing something right.
firms that are able to consistently post ROEs above 15 percent are generating solid returns on shareholders’ money, which means they’re likely to have economic moats.
Use 6 percent to 7 percent as a rough benchmark—if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers.
A firm that has consistently cranked out solid ROEs, good free cash flow, and decent margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results. Consistency is important when evaluating companies, because it’s the ability to keep competitors at bay for an extended period of time—not just for a year or two—that really makes a firm valuable. Five years is the absolute minimum time period for evaluation,
In general, there are five ways that an individual firm can build sustainable competitive advantage: 1. Creating real product differentiation through superior technology or features 2. Creating perceived product differentiation through a trusted brand or reputation 3. Driving costs down and offering a similar product or service at a lower price 4. Locking in customers by creating high switching costs 5. Locking out competitors by creating high barriers to entry or high barriers to success
Think about an economic moat in two dimensions. There’s depth—how much money the firm can make—and there’s width—how long the firm can sustain above-average profits.
For concrete evidence of an economic moat, look for firms that consistently earn high profits. Focus on free cash flow, net margins, return on equity, and return on assets.
Companies generally build sustainable competitive advantages through product differentiation (real or perceived), driving costs down, locking in customers with high switching costs, or locking out competitors through high barriers to entry.
Think about economic moats in two dimensions: depth (how much money the company can make) and width (how long it can sustain above-average profits).
statement of cash flows, which records all the cash that comes into a company and all of the cash that goes out.
confusing concept called accrual accounting. Here’s how it works. Companies record sales (or revenue) when a service or a good is provided to the buyer, regardless of when the buyer pays. As long as the company is reasonably certain that the buyer will eventually pay the bill, the company can post the sale to its income statement.
The income statement strives to match revenues and expenses as closely as possible—that’s
the cash flow statement cares only about the dollar bills that go in and out the door, regardless of the timing of the actions that generated those dollar bills.
The balance sheet is like a company’s credit report because it tells you how much the company owns (assets) relative to what it owes (liabilities).
• The income statement shows how much the company made or lost in accounting profits during a year or a quarter. Unlike the balance sheet, which is a snapshot of the company’s financial health at a precise moment, the income statement records revenues and expenses during a set period, such as a fiscal year.
the statement of cash flows—records all the cash that comes into a company and all of the cash that goes out.
Accrual accounting is a key concept for understanding financial statements. The income statement matches sales with the corresponding expenses when a service or a good is provided to the buyer, but the cash flow statement is concerned only with when cash is received and when it goes out the door.
The income statement and cash flow statement can tell different stories about a business because they’re constructed using different sets of rules. To get the mo...
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Equity represents the value of the money that shareholders have invested in the firm,
The cash flow statement is divided into three parts: cash flows from operating activities, from investing activities, and from financing activities.
The “cash flows from operating activities” section comes first and it tells you how much cash the company generated from its business. This is the area to focus most of your attention
Operating cash flow minus capital expenditures equals free cash flow, or the amount of cash the company generates after investing in its business.
Keep an eye on the trend in accounts receivable compared with sales. If the firm is booking a large amount of revenue that hasn’t yet been paid for, this can be a sign of trouble.
• When you’re evaluating a company’s liabilities, remember that debt is a fixed cost. A big chunk of long-term debt can be risky for a company because the interest has to be paid no matter how business is doing.
Be wary of companies that report “nonrecurring” charges, particularly if they make a habit of it. All kinds of expenses c...
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The statement of cash flows is the true touchstone for corporate value creation because it shows how much cash a company is generating from year to year—and cash is what...
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When you’re analyzing a company, make sure you can understand how a dollar flows through the business. If you can’t do this, you probably don’t understan...
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Analyzing a Company—The Basics
