Picking a good company for the long term

CliffNotes Investing in the Stock Market, pp57-60:

1: EPS: Earnings per share
The first bit of information you need to know about a company
is how much money it is making. For ease of comparison
among companies, earnings are universally expressed as
earnings per share (EPS). These earnings are what’s left from
gross revenues after expenses, taxes, bad debts, and so on have
been subtracted.
For publicly traded and listed companies, these earnings and
other financial data come from audited financial records
approved by a Certified Public Accounting firm.
2: P/E ratio
The P/E ratio shows the relationship between the stock’s current
price and its reported annual earnings.
A P/E ratio of 20 means that a company earns five cents for
every $1.00 you invest. This does not mean that the company
pays a dividend of five cents per share. The company
may pay no dividend at all.
The P/E ratio tells us how much you have to pay to buy those
earnings per share. In the past, P/E ratios hovered between
10 and 20, but with the surge in stock prices in the 1990s,
P/E ratios in the 40 to 60 range and higher are increasingly
common.
Generally, the lower the P/E ratio, the more preferable the
stock. Profit, another name for earnings, is what drives the
price of stocks and payment of dividends.
3: ROE: Return on stockholders’ equity
The ROE, or return on equity, looks at the company’s profitability
from a different point of view. This figure tells you
what the company has done in the past with the money that
stockholders have invested in it.
An ROE of 15% or better is very good and maybe even outstanding,
depending on the industry. If you discover in your
research that one company’s ROE is above 15% and another
similar company’s ROE is 5%, the company with the higher
ROE is clearly the better choice. For a balanced perspective,
look at the trends for three or more years.
4: Beta
Beta is a measure of how volatile a stock’s price is relative to
the stock market as a whole. A beta of 1 means that the stock
moves up and down exactly at the same pace as the market
as a whole.
A beta greater than 1 indicates that a stock goes up or down
faster than the market as a whole. A beta of less than 1 means

that the stock’s up or down moves are smaller than the market
as a whole. Generally, it is a good idea to avoid stocks
with betas above 1 because these stocks are more volatile and
more risky.
5 and 6: 5-year sales and earnings
history
The 5-year sales and earnings histories each tell you something
different. For any stock that you buy, you want to see sales
and earnings rise together, with earnings moving upward a
bit faster. Earnings that outpace sales usually indicate that
the company is becoming more efficient in holding its costs
down and in expanding its market.
7: Company size
Why is company size important? Generally, if you’re looking
for maximum appreciation in stock values over time, you
want to check out smaller companies where the potential for
rapid growth is greater than large established companies (such
as those companies included in the Dow Jones Industrial
Average). Older, larger companies tend to be less nimble and
become top-heavy with bureaucracy. The best bets for
stronger long-term growth are among the smaller companies,
typically those under $200 million in market capitalization.
8: Relative industry strength
You want to look at companies that are ranked at least in the
top 25% of their industries — preferably higher.
You can find information on relative industry strength in
Value Line and Investor’s Business Daily. The analyses in these
publications are excellent and are not done by people trying
to sell you stocks.

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I use the following Rules for bargain hunting:

Rules:

1. Pick an industry or sector. Choosing a sector is more important than choosing what company. The industry it is in must be at the bottom of its business cycle and the industry is now going up. Entry barrier to the market should be high. Choose an industry you understand well. If you are a doctor, choose biotech or pharmaceutical. If you are an programmer, choose IT. If you are a shipping clerk, you understand the shipping sector better than 99% of the investing population and possibly the best Wall Street analysts. Having said that, there is no substitute to reading the Financial Times and WSJ everyday. Watching Bloomberg and CNBC doesn't count.

2. Pick a company which is a leader of the industry in its country of operation. Does it have a good market share? Is it a monopoly or obligopoly? A distinct competitive advantage? Study its prospectus, the latest 3 annual reports and the latest interim report. More importantly, study its competitors' prospectus, annual reports and latest interim report. Understand its strategic partners, substantial shareholders, major suppliers and customers.

3. Does it have a new and innovative product and/or service, (Peter Lynch). Perhaps a new management team: CANSLIM. The key is CHANGE!!!!

4. It must have a good management team. Most of its executive directors must at least have a bachelor degree, preferably obtained in the US or the UK (graduate degrees from Ivy League and Oxbridge a plus). Some of them could have been with the company for more than 10 years. New comers may be good (CANSLIM). Either the chairman or at least one executive director should have worked at a global multinational enterprise for more than 20 years (eg S&P500, FTSE100, Nikkei225, Fortune Global 500). One or two executive directors with good knowledge of China would be good. A team with a balanced mix of Western and PRC business background would be ideal. Lastly, management should care about Corporate Governance. INED and NED may be a source of business connection and growth prospect. Make sure your company or its directors don't appear in Webb-site.com's Hall of Shame or any of Webb's Watch Lists.

5. Substantial shareholder should be an executive director/chairman. He must have a big stake at the company, otherwise he might not care much about the company's prospect (曹仁超Tso Yan Chiu). Alternatively, the company can be run entirely by professionals like HSBC ... Public flotation shouldn't be too huge (CANSLIM). Ideally, the company has just had its first or second institutional investors coming in.

6. Excellent bottomline: Gross profit margin above 15% (曹仁超Tso Yan Chiu).... profit margin not too thin (曹仁超 and Buffett)... If it's too low, it's probably not a good company; if it's too high, it's probably unsustainable [Inside the Guru Mind: Warren Buffett]. Also look at EBITDA (for high growth tech/telecom) or EBITDAX (for oil/petrol)... PEG less than 1.2 and EPS's growth 15 to 30% (Lynch). Other GARP investors might adopt EPS grwoth of 10 to 20%. Value investors might live with PEG less than 1. Must examine Cash Flow generated from operation, investing, & financing. CANSLIM says current quarterly earning must be up at least 25% from previous quarter last year, but Peter Lynch says 15 to 30%. CANSLIM also says annual revenue up 25% three years in a row. Value investors might insist that its dividend yield be at least two-third of AAA long-term bond rate. Growth investors suggests steady growth in dividend yield rather than rapid surge. They might even insist that earnings growth should be at least 7% per annum compounded over the last 10 years. NAIC suggests looking at the following

• EPS growth from 5 to 12% depending on size of the company. The smaller the market cap, the faster its earning growth ought to be. NAIC also advise consistent EPS for 5 years is essential; 10 years even better. For HK and PRC companies, growth rate ought to be adjusted at least 5 to 10% upward.
• If company exceeds its previous five-year average of pre-tax profit margins as well as those of its industry, then that would be good.
• Productive use of equity is reflected in an increasing ROE. Again, analysis of this metric should be relative: a company's present ROE is best compared to the five-year average ROE of the company and the industry.
• Some GARP investors insist on positive cash flow.
  

7. Fair Intrinsic Value:

• Discounted Cash Flow with EPS, DPS & Cash Flow based on FTE, APC, WACC or maybe TCF approaches
  
• P/B (banking stock), GARP insists that P/B must be below industry average.
  
• P-to-NAV discount (real estate stock); stock price should be no more than tangible book value.
• CANSLIM and Value Investors say high P/E is not necessarily an indication of overvaluation (but you can't exactly pretend high P/E is not there). Compare it against competitors'.
  

If market capitalization is too large, there isn't got too much growth ahead of itself, eg HSBC. But look at the market cap of CNOOC, ICBC, Sinopec & PetroChina, they are huge; everyone agrees they still have huge growth potential. Compare its Balance Sheet, P/L, Cash Flow statements with two or three of its competitors. You may want to pick a company which is a constituent of the various Hang Seng Indexes, MSCI EFE, or S&P/HKEx LargeCap/GEM Index, but it's underperforming comparing with other constituent companies (Dogs of Dow). Value investors might pick a company if its P/E is in the lowest 10% percentile.

Share price should be no more than two-thirds of intrinsic worth. If share price is less than two-third of its current assets, it is real bargain (but probably in financial trouble).

In valuating a company, have a margin of safety.

8. Other financial numbers: growing ROE (Buffett) three years in a row (i made this second part up myself) and ought to be above the yield of long-term bond [Inside the Guru Mind], growing ROA three years in a row (i made this up myself), Magic Formula Investing also suggests looking at ROCE as well. Warren Buffett says you should look at Capital Expenditure as well. GARP and Lynch insists that ROE must be higher than its competitors and overall industry average.

9. Not too much debt... Debt-to-Equity below 35% (Peter Lynch's One up wall street). Henry Paulson recently (April 2008) said in Beijing that Chinese people save too much and borrow too little, while Americans do the reverse. Compare the company's balance sheet with two or three of its competitors. For PRC companies, 35% as suggested by Lynch may be too high. Depending on industry, try 15 to 30% instead.... Value investors might insist current assets exceed current liabilities by 2 times.

10. Timing: Buy it when directors, institutional investors (eg, Li Ka Shing) or strategic partners have recently bought some shares. Ideally, the company had recently had its first or second institutional investor (eg mutual or pension funds) coming in. Technical indicators of the company (eg, trend, pattern, slow stochastic, RSI, MACD) also signals a buy... If the company has a high positive beta co-efficient, pay attention to the overall market level and sentiment. Some value investors pick companies if a company is at a 12-month low or at half of its recent 12-month high. In short, use fundamentals to pick companies and sectors, but use mostly technicals (with minor assistant from fundamentals) for entry and exit timing.

11. You should produce a list of rankings based on the above criteria. Own three to six companies at a time based on your ranking (曹仁超). Buffett says rarely would a person be able to make any money on his or her seventh company. Sell when:-

• the entire sector or industry is declining
  
• the overall market is declining, especially if your company has a high positive beta coefficient.
  
• the technical indicators give you a sell signal (eg, trend breakout, stochastics, MACD, RSI, bollinger bands)
• two to three of the Rules above are no longer true
• always cut losses at max 15% (John Templeton). CANSLIM on the other hand suggests cutting losses at 7 to 8%. I suggest you look at market conditions and technical indicators for sell signal. 5 to 10% seems reasonable.
  
• don't take profit just because it had risen 2 or 3 times: (Buffett)
• more selling criteria at Money Management below.

12. Money Management.

13. For IPO, who is the sponsor? Good sponsors are BNP Peregrine, Merill Lynch, Morgan Stanley.