Stock picking – the Warren Buffet way

1. Stock picking – the Warren Buffet way S G Raja Sekharan 1

3. My portfolio performance last year (as of 30th Dec 2012)

4. . Warren Buffet –The sage of Omaha

5. . World’s wealthiest – Forbes 2013 Carlos Slim Helu & family –Mexico -$ 73 B – Mobile companies William Henry Gates –US - $67 B –Microsoft Warren Buffet – US - $ 53.5 B –Berkshire Hathway

6. . One of the most successful investors in the world Noted for his adherence to “Value Investing” Also known for his personal frugality Born in 1930, second of three children, father was a stock broker and politician Early in school age, he started earning by selling soft drinks and delivering paper At 14 years, with his earning, he bought 40 acres of land –which he rented out He went to Columbia for graduation - studied under Benjamin Graham –father of Value investing Warren Buffet –The sage of Omaha

7. . Benjamin Graham refused to hire him –saying Stock broking and Wall street was not for him Warren Buffet came back –got married and stayed in Omaha with his father’s brokerage Benjamin Graham changed his mind and gave him a job in his NY office Value investing means seeking stocks selling at extraordinary discounts to the value of it’s underlying assets –defined as “Intrinsic value” Buffet went a step beyond Value investing – he looked at the value of a good management team, product’s competitive advantage in marketplace Warren Buffet –The sage of Omaha

8. . In 1956, he came back to Omaha and launched Buffet Associates Ltd In 1962, already a 30 year old millionaire –he joined forces with Charlie Munger This collaboration eventually resulted in the investment philosophy of Value investing that helped Buffet to get where he is today Along they way, they purchased a dying textile mill called Berkshire Hathaway - as a long term investment Cash flows from this mill were used to fund other investments – eventually other investments overshadowed the textile business In 1985, Buffet shut down the textile business – but continued with the company as a holding company Warren Buffet –The sage of Omaha

9. . Buffet picks up stocks in what he believes are well managed under valued companies When he purchases any stock – his intention is to hold the stocks for infinite period of time Coke, Amex, Gillette etc are such stocks held by him for many decades He also purchases companies outright and let’s their management teams handle their day to day business Warren Buffet –The sage of Omaha

10. . • He believes that an investor and a businessperson should look at a company in the same way. The businessperson wants to buy the entire company while an investor wants a part • The first question any businessperson will ask is, ‘‘What is the cash generating potential of this company?’’ • Over time, there will always be a direct correlation between the value of a company and its cash generating capacity. The investor would benefit by using the same business purchase criteria as the businessperson Warren Buffet –The sage of Omaha

11. . • The basic idea of investing are to look at stocks as business, use the market’s fluctuations to your advantage, and seek a margin of safety. • Warren Buffett seeks first to identify an excellent business and then to acquire the firm if the price is right • Once a good company is identified and purchased at an attractive price, it is held for the long-term until the business loses its attractiveness or until a more attractive alternative investment becomes available. Warren Buffet –his investment philosophy

12. . • Buffett seeks businesses whose product or service will be in constant and growing demand. In his view, businesses can be divided into two basic types: • Commodity-based firms, selling products where price is the single most important factor determining purchase. • They are characterized with high levels of competition in which the low-cost producer wins because of the freedom to establish prices. Management is key for the long-term success of these types of firms. • Buffett avoids commodity-based firms. Warren Buffet –his investment philosophy

13. . • Buffett seeks businesses whose product or service will be in constant and growing demand. In his view, businesses can be divided into two basic types: • Consumer monopolies, selling products where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique. • Buffet is interested in consumer monopolies Warren Buffet –his investment philosophy

14. . • Businesses that make products that wear out fast or are used up quickly and have brand-name appeal that merchants must carry to attract customers. As per Warren Buffet – there are three types of consumer monopolies

15. . • Businesses that provide repetitive consumer services that people and businesses are in constant need of. As per Warren Buffet – there are three types of consumer monopolies

16. . • Communications firms that provide a repetitive service that manufacturers must use to persuade the public to buy the manufacturer's products. Advertising agencies, magazine publishers, newspapers, and telecommunications networks are good examples As per Warren Buffet – there are three types of consumer monopolies

17. . • The firm has low profit margins (net profit divided by sales) • The firm has low return on equity (earnings per share divided by book value per share) • Absence of any brand-name loyalty for its products • The presence of multiple producers • The existence of substantial excess capacity • Profits tend to be erratic • The firm's profitability depends upon management's ability to optimize the use of tangible assets. Warren Buffet – how does he spot a commodity based business

18. . • The firm has managed to create a product or service that is somehow unique and difficult to reproduce by competitors due to • Brand name loyalty • A particular niche that only a limited number of companies can enter • An unregulated but legal monopoly like patents • A strong upward trend in earnings • Conservative financing • A consistently high return on shareholder's equity • A high level of retained earnings • Low level of spending needed to maintain current operations • Profitable use of retained earnings Warren Buffet – how does he spot a consumer monopoly

19. . Target successful businesses--those with expanding intrinsic values; Value is measured by the ability to generate earnings and dividends over the years; Buy at a price that makes economic sense, defined as earning an annual rate of return of at least 15% for at least five or 10 years (I would opine, in India with Inflation of 10%, we need to target 20% returns). Warren Buffet –his investment philosophy

20. There are 14 questions that we need to answer • We will take one corporate example –Asian Paints and analyze the stock to find out • whether is it worth at all? and if yes • at what price one must buy the Asian Paints stock We will now get into specifics

21. Paint industry in India –an overview • Market size of paints in India is Rs 260 Bn as of FY 2012 and has grown @ 15% in the past year. • Unorganized sector consisting of about 2000 units control 35% of the market • Organized sector has 65% market share –top players in this sector are Asian paints (34% of the 65% organised mkt), Berger Paints(15%), Kansai Nerolac (9%) and Akzo Nobel (8%)

22. Paint industry in India –an overview Top 4 paint companies in India

23. Paint industry in India –an overview • Low technology and low capital costs help the unorganized sector – however the reduction in excise duties from 40.5% in 90’s to the current 16% has helped the large units to compete effectively. • The paint industry is raw material intensive -on an average, raw materials account for 60% of net sales (industry average). In case of small-scale units it forms up to 70% of the net sales.

24. Paint industry in India –an overview • Around 300-400 raw materials are required to manufacture different kinds of paints (pigments, solvents and additives). • The high number of raw materials and finished goods highlights the working capital intensity of the sector • Most of the raw materials are petroleum based.

25. Paint industry in India –an overview • The products of the paint industry can be classified into two major segments decorative (architectural) paints and industrial paints • 70% of the paints sold in India are decorative paints – entry barriers here are investments in branding and dealer networks –Asian paints is the leader in this category. • Industrial paints are used in automotive, marine and other applications –Kansai Nerolac supplying to Maruti makes it the market leader in this market.

26. Paint industry in India –an overview • Supply exceeds demand in both the decorative as well as the industrial paints segments. • Brand, distribution network, working capital efficiency and technology play a crucial role • The market grows at 1.5 to 2 times the GDP and with India growing at 8%, the growth is expected to be around 12-15% in the coming years. • Decorative paints are expected to witness higher growth going forward due to boom in housing sector

33. . Is it a consumer monopoly or commodity business –does it have an identifiable durable competitive advantage? • Consumer monopolies typically have high profit margins because of their unique niche • Beyond high profit margins, look for companies with operating margins and net profit margins above their industry norms • Also look for strong earnings and high return on equity will also help to identify consumer monopolies. • Look at a detailed study of the firm's position in the industry and how it might change over time. Questions to determine the attractiveness of business – Q1

34. . Questions to determine the attractiveness of business – Q1

35. . Is it a consumer monopoly or commodity business –does it have an identifiable durable competitive advantage? • Consumer monopolies typically have high profit margins because of their unique niche • Beyond high profit margins, look for companies with operating margins and net profit margins above their industry norms • Also look for strong earnings and high return on equity will also help to identify consumer monopolies. • Look at a detailed study of the firm's position in the industry and how it might change over time. • YES - Asian Paints has an identifiable durable competitive advantage in the form of it’s brand leadership and it’s distribution network in India Questions to determine the attractiveness of business – Q1

36. . Do you understand how the product /service/business model works? • Only invest in industries that you understand – for example Buffet refused to invest in ecommerce companies during the dot com boom because he did not understand their business • Yes - Asian Paints – the company buys or makes raw materials, manufactures the paints, distributes it through it’s network and sells it to B2C and B2B customers – profitability comes from efficient operations, volumes and ability to get a premium due to brand positioning . Questions to determine the attractiveness of business – Q2

37. . What is the chance that the product /service/business model would be obsolete in the next 20 years? • Will there be a market for this product 20 years from now • If there is going to be technological changes envisaged, then will this company have an upper hand still? • Yes - Asian paints – The paint product may evolve technically – but paints as a category will survive and Asian paints is expected to have an upper hand due to it’s size and reach. Questions to determine the attractiveness of business – Q3

38. . Does the company allocate capital exclusively in the realm of expertise? Where have been their investments in the past 5-10 years? Does the company stick with what it knows? Yes - Asian Paints has not invested in unrelated diversification in the past 10 years Questions to determine the attractiveness of business – Q4

39. . What has been the company’s EPS history and growth rate • The company must show a consistent growth in EPS over the past 10 years • Erratic growth and dips in EPS would mostly make the company unattractive for investment unless there is a clear enough reason visible as to why it happened. • Yes - Asian Paints has a consistent EPS growth in the past decade and has a EPS CAGR of 26.1% Questions to determine the attractiveness of business – Q5

40. . Is the company consistently earning high Return on equity The company must show a consistently high ROE over the past 10 years – ROE = reported net profit /Net worth Yes – Asian paints has an ROE ranging from 27.16% to 51.69% with an average ROE of 37.0% Questions to determine the attractiveness of business – Q6

41. . Is the company consistently earning high Return on total capital? • The company must show a consistently high Return on total capital employed over the past 10 years • ROCE = Reported net profit /Total liabilities in BS • Yes -Asian paints has a high ROCE ranging from 18.71% to 43.52% with an average ROE of 28.76% Questions to determine the attractiveness of business – Q7

42. . Is the company conservatively financed? • Consumer monopolies tend to have strong cash flows, with little need for long-term debt • Screen for companies with no debt or low debt – look at the interest coverage ratio –compare with industry peers • Yes -Asian paints has a debt ranging from Rs. 169 crores to Rs.336 crores and a net profit ranging from Rs. 143 crores to Rs. 1159 crores – the company is conservatively financed Questions to determine the attractiveness of business – Q8

43. . Has the company been buying back its shares? • Buffett prefers that firms reinvest their earnings within the company, provided that profitable opportunities exist. When companies have excess cash flow, Buffett favours shareholder- enhancing manoeuvres such as share buybacks • This answer if Yes is good - but a NO answer does not disqualify the stock. • No –Asian paints has not bought back any shares in the past 10 years Questions to determine the attractiveness of business – Q9

44. . Is the company free to adjust prices to inflation? True consumer monopolies are able to adjust prices to inflation without the risk of losing significant unit sales. Questions to determine the attractiveness of business – Q10

45. . Is the company free to adjust prices to inflation? True consumer monopolies are able to adjust prices to inflation without the risk of losing significant unit sales. Yes – Profitability ratio of Asian paints is consistently around 8.65% over the past 10 years – that means that inflation does not impact the profits of Asian Paints Questions to determine the attractiveness of business – Q10

46. . Does company need to constantly reinvest in capital? • Retained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better. • Not really – Asian Paints does not have a large capex for investment in plant and machinery – the main investments are in branding and the SGA as a % of Net sales is around 18%% for the past decade – this is around what any FMCG company would spend. Questions to determine the attractiveness of business – Q11

47. . What is the initial rate of return (IRR) and relative value to a Govt bond? • EPS for the year divided by the long-term government bond interest rate. The resulting figure is the relative value - the price that would result in an initial return equal to the return paid on government bonds. • We then have to look at the CAGR of the EPS as well. • Asian Paints – assuming a 8% govt bond rate – and based on the current EPS of 120.88 – the relative value of govt bond would be –Rs 1511 • With the current share price of Rs. 4553 – the Asian Paints share gives a pretax return of 2.65% with the returns growing at 26.1% p.a. Questions to determine the attractiveness of business – Q12

48. . What is the projected share value and return on investment using historical earnings growth rate: • Calculate the CAGR of EPS for the past 10 years • Calculate the average dividend payout ratio (DPS/EPS) for the past 10 years • Calculate the average PE for the last 10 years • Asian Paints – • CAGR of EPS is 26.10% • Average Dividend payout ratio is 42.58% • Average PE for the last 10 years has been – 23.49 Questions to determine the attractiveness of business – Q13

49. . What is the projected share value and return on investment using historical earnings growth rate: • Calculate the EPS for the next 10 years as follows: EPS of year 2 = EPS of year 1 * CAGR of EPS • Calculate the dividend payout for the next 10 years as follows: Dividend payout for year 2 =EPS for year 2 * average DP ratio • Calculate the sum of all the dividends paid for the next 10 years Questions to determine the attractiveness of business – Q13

50. Asian Paints –Historical earnings growth rate method