Indian Institute of Foreign Trade, Kolkata

MBA (IB) 2009-11, trimester IV

Security Analysis and Portfolio Management
The Two approaches to investing. It is far easier to follow the Top down approach because it is broader and
prominent to identify. For instance if you would have been bullish on IT services you would have made good
money buying any of the Indian software stocks.

Bottom Up Top Down

Economy Check for the GDP growth rate, current account deficit, GDP to market cap ratio, Govt. policies and
attitude to reforms, restrictions or ease on foreign capital movements, interest rates, money supply etc..

Markets: Check for the state of trading automated or outcry, the general PE ratio of the market, corporate
governance practices and company disclosures, trade settlement and risk management systems etc.

Sectors: Check for the long-term sustainable advantage of that sector, whether that sector is cyclical (cyclicals
should never be long term bets) or not, the kind of entry barriers that sector possesses etc.

Company: Check for the PE ratio, the market cap to sales, sustainable growth rate and others. Also see stock
computational tools
India - Cross Section of Business opportunities
Emerging Businesses Global Outsourcers
Retailing

Telecom, Internet

Print and Electronic Media

Information Technology
Restaurants
Pharmaceuticals
Real Estate
Engineering
Insurance

Infrastructure

Consumer
Commodities Domestic Demographics
FMCG
Oil
Auto (Two wheelers and Four
wheelers)
Metals
Retail Banking

Investing vs. Speculating

"For stock speculation is largely a matter of A trying to decide what B, C and D are likely to think -
with B, C and D trying to do the same". - Warren Buffet

"An Investment operation is one which upon, thorough analysis promises safety of principal and an
adequate return. Operations not meeting these requirements are speculative" - Benjamin Graham

"Investment is an activity of forecasting the yield on assets over the life of the assets. speculation is
the activity of forecasting the psychology of the market" - John Maynard Keynes

Whenever you rely on knowledge and know what you are doing it is termed as investing but
Speculation is when you rely on luck and do not know what you are doing.
 The Investment Cycle

BUY

EPS PE

SELL

Perception
Performance Check the
Pe Drivers
Buying and selling a
stock depends upon:

• Dynamic Factors
• Quantitative and Qualitative Factors

• Absolute and Relative factors

Consequences of FII

Economy

• Has no effect on the GDP

• Inflationary

Stocks

• Stocks rally upwards fuelled by a flood of liquidity

• Companies have more access to foreign money

Ownership with control Foreign Direct Investment (FDI)

The FDI hot spots!
Asian InvestorsEuropean InvestorsNorth American investors
China China China
 India India India
Hong Kong Poland United States
Australia Russia United Kingdom
Vietnam United States Brazil

The Foreign Money: What how and why?

Foreign Portfolio Investment also known as FII
Ownership Without Control
Investments
Top 10 Flls In India Based On M-Cap
HSBC
Morgan Stanley
Merrill Lynch
Goldman Sachs
CLSA
Aberdeen
Copthall
Citi
Genesis
Capital

Top FII held Companies

Infosys
Reliance Industries
Bharti Tele
HDFC
ONGC
Satyam
HDFC Bank
SBI
BHEL

Markets reacts only temporarily to political and military news but the reaction to fundamental news is
permanent and pronounced. See the chart below when ever the Index fell in the backdrop of political or
military news (terrorist attacks, wars etc) it recovered fully after a year. Therefore investors should not sell on
news that do not affect the Company fundamentals.As always this is one of the hardest things to do because
when prices fall people can lose sleep irrespective of whether they are long term or short term investors.
 Date of event Index Percentage of Reasons One year later Index Gain Percentage
fall for the fall
04-04-2000 5053 7.15% Technology 04-04-2001 3605 -29%
crash
11-04-2001 3458 4.26% Tehelka Expose 11-04-2002 3479 1%
12-09-2001 3150 3.73% W.T.C 9//11 12-09-2002 3126 -1%
14-09-2001 2987 5.27% W.T.C 9/11 14-09-2002 3098 4%
17-09-2001 2830 5.27% W.T.C 9/11 17-09-2002 3076 9%
31-03-1997 3666 8.26% Sitaram Kesari 31-03-1998 3896 6%
pulls support
10-06-1998 3469 4.52% Pokhran Blast 10-06-1999 4041 17%
15-06-1998 3349 5.81% Pokhran Blast 15-06-1999 3951 18%
26-04-1999 3406 4.74% Jayalalitha 26-04-2000 4534 33%
Withdraws
support
17-05-2004 4505 11.13% B.J.P loses 17-5-2005 6466 43.52%
power and a Left
front supported
Congress Govt.
is elected

Markets Climb a Wall of Worry

The Sensex has returned about 18.62 % compounded annual return over the past 28 years in spite of:

• 1 War (With Pakistan – Kargil 1999). Increasing Terrorism and threats to Internal Security (Punjab, J&K,
Assam , Naxalite problem in Bihar & other parts of India).

• 2 Major financial scandals and a number of minor ones (Harshad Mehta, Ketan Pareikh, C.R.
Bhansali,Sanjay Agarwal etc).
 • 2 assassinations of Prime ministers (Indira Gandhi & Rajiv Gandhi).

• Number of communal riots (Ayodhya, Godhra - They keep happening with immaculate consistency).

• More then 11 different Governments perusing different manifestos and putting all of them under a common
banner titled Common Minimum Program..

• Poor Monsoons on more then 3 to 4 occasions.Each year the market speculates as to how the Monsoons have
hit the coast of Kerala but over alonger period of time they do not matter. More so with increasing irrigation
systems and development our dependence on monsons will come down further.

• Mortgage of Gold to tide over the foreign exchange crisis (In 1991 the Indian Govt. mortgaged Gold to the
Bank of England).

• Coalition governments have governed major portion of the last 25 years.

• Numerous number of natural calamities and disasters (Tsunami 2004, Gujarat Earthquake 2001, Surat
Plague 1995).

Crashes and Bubbles - No Tree ever touches the Sky

Percentage rise in the Bull Market
Asset class Percentage fall in the market
market tenure
Tulips (1634) 5900%+ 100% 36 months
South Sea Bubble 800%+ 96%+ 60 months
The Mississippi current 700%+ 98%+ 48 months
The US Railroad
accident Several times over 100% in several cases 180 months
Dow (1929) 345%+ 90%+ 13 months
Silver (1979) 710%+ 90%+ 12 months
Gulf Stocks 7000%+ It continues 54 months
 50%+ GDP contraction in dollar
South East Asia (1997) Several times over 12 months
terms
NASDAQ 500%+ 78%+ 60 months

The Tulip-Bulb Craze

When: 1634-1637

Where: Holland

The amount the market declined from peak to bottom: Very difficult to quantify but at the peak of the
market, a person could exchange a single tulip for an entire strech of land and, at the bottom, that tulip was
the price of a few tomatoes.

Synopsis:

• In 1593 the Dutch were introduced to Tulips for the first time. These tulips were imported from
Turkey were in great demand and traded at fancy prices.
• In due course these tulips were affected by a non-fatal virus known as mosaic, which did not harm
the tulips per se but altered them, causing shades of color to appear on the petals. These color
patterns came in wide varieties and increased the rarity of the original flower.
• Thus the prices of tulips began to rise depending upon how the markets valued the virus alterations
Speculation increased in the tulip market as it started attracting new traders eager to make quick
money.
• The true bulb buyers started to stock up bulbs for the growing season thereby depleting the supply
further. This increased the demand supply gap. Soon, prices were rising thick and fast encouraging
people to trade their cash, gold, land and anything else they could liquidate to buy more tulip bulbs.
• The Dutch held on to their bulbs with a view to selling them to the innocent and uninformed
foreigners, thereby reaping enormous profits. Meanwhile the originally overpriced tulips enjoyed a
twenty-fold increase in value--in one month!
• Since tulips bulbs enjoyed extensive over pricing some smart people decided to sell and lock in into
the profits.
• A domino effect of progressively lower prices took people by surprise as everyone tried to sell. As
price began to slide people panicked and rushed to sell regardless of the losses
• When prices fell the participants refused to honor contracts. It suddenly dwelled upon speculators
that they traded their homes for a piece of greenery. Chaos and Confusion enveloped the land.
Amidst all this the government attempted to halt the crash by offering to honor contracts at 10% of
the face value. The market plunged even lower making such restitution impossible.
• No one emerged unscathed from the crash. Even the people who had locked in their profit by getting
out early suffered under the following depression. The effects of the tulip craze left the Dutch very
hesitant about speculative investments for quite some time.

The South Sea Bubble

When: 1720
Where: United Kingdom

The Fall: Stocks in the South Sea Company traded for 1000 British pounds and when the company was
finally liquidated the shareholders received 33 pounds for each share.

Piquant aspects: Newton doubled his money in the South Sea Company. He made a profit of 7,000
pounds and then the hype got to him again. He re-entered again at the peak and lost 20,000 pounds,
which amounts to around Rs 200,000 crores adjusted for 5% inflation. Yes Rs 2,00,000 crores. It was
then that Newton said " I can calculate the motion of heavenly bodies but not the madness of people".
Did any one say that even Newton could not defy the laws of gravity

Synopsis:

• John Blunt having connections with influencing politicians beat the Bank of England in a bid to
take over the Govt. debt of 7.5 million pounds by issuing equity of the South Sea Company.
• The idea was to compensate the debt holders with the stock of the company . At the time of the
act being passed in parliament the stock traded at 128 pounds. Blunt thought that the price could
be driven up to 300 pounds and the debt extinguished by providing lesser number of over
valued stock instead of cash. The remaining shares could be re-issued since the debt could be
exchanged for a lesser amount of shares.
• The company purchased the "rights" to all trade in the South Seas. The companies that offered
stock at that time were all solid but extremely illiquid buys. For instance the East India Company
that paid substantial tax-free dividends had a meager 499 investors. A large section of the population
had money to invest and was unsuccessfully looking for companies to put in their money. At that
time The South Sea Company perceived to be the most lucrative monopoly on earth.
• Cashing in on the scarcity for ownership paper The South Sea Company successfully placed its
shares at 300 pounds and 400 pounds respectively in April 1720.
• The popular conception was that huge amounts of gold and jewels could be received in
exchange for wool and fleece by trading with the Mexicans and the South Americans. Nobody
questioned the repeated re-issues of stocks by the South Sea Company--people just bought the
expensive stocks as fast as they were offered
• This was followed by another innovative scheme where investors were allowed to buy the stock
at 1000 pounds on installments by making an up front payment of 10% ie.100 pounds.
• A domino effect of progressively lower prices took people by surprise as everyone tried to sell. As
price began to slide people panicked and rushed to sell regardless of the losses
• Buoyed by the ease with which money could be raised other companies rushed in to offer shares
in a bid to make a quick buck.
• Sensing that this new supply would create competition for speculators' money Blunt filed writs
against these companies, which he claimed were operating illegally.
• The Court upheld his petition and some of the outlawed stocks collapsed triggering a margin
call since everyone had been investing on margin.
• The shares of the South Sea Company also joined in the decline and it collapsed from around
1000 pounds in July at about 200 pounds in September.
• Blunt tried to persuade the Bank of England for financial assistance to stabilize the shares at
400 pounds but the Bank refused. The fraudulent promoter had already cashed out of his personal
holdings by then.
 • When questioned Blunt argued that he did not remember anything out of the transaction but later
testified that the object of the company was to defraud the investor under the garb of lucrative
business opportunities. The company's treasurer eloped from town while some of the directors
were forced to return back some money.
• The company was finally wound up with the shareholders receiving 33 pounds per share

The US Rail Road Accident (1850's)

When: In the 1850's

Where: USA

The amount the market declined: More then 1000 banks failed and the New York Mining Exchange was
forced to close down .

What they gave us A network of Rail and Road Transport line connecting the whole of the United States .

Synopsis:

• In the early part of the 19 th Century the US was primarily a cotton growing nation with insignificant
investments in Infrastructure.
• The first part of the Rail Road boom was a result of the Canal Construction drive which was initiated
by the completion of the Erie Canal which cut down shipping and travel costs by 90% from cities
like Detroit , Buffalo and Cleveland . Another Canal was built to link the Great Lakes to the ST.
Lawrence River . The two Canals were enormously successful as they integrated the grain producing
centers to New York .
• Canals in those days were as popular as Internet stocks were in the late1990's or oil stocks were in
the early 1970's.
• The booming business attracted huge doses of capital from Europe . In 1853 foreigners owed 26% of
all US assets.
• The common practice by unscrupulous promoters is to offer more paper as prices of their shares rose
and the US was no different. This increased over supply of paper created a huge over hang which
depressed prices even while business continued to grow at its usual pace.
• Meanwhile unrest and war in Europe signaled rising interest rates. An over supply of paper by the
Railroads coincided with European investors pulling out from US bringing down stocks from their
highs.
• In 1857 the Ohio Life and Trust Company failed and a ship carrying gold from California to the East
Coast sunk in the Ocean. This created a panic fro the Banks in the East Coast.
• In the cascading problem more then 1000 Banks and financial Intermediaries were unable to keep up
to their commitments

Plummeting in the Great Depression (1929) - Black Monday,

Thursday, and Tuesday
When: October 21, 24, and 29, 1929
Where: USA

The amount the market declined from its peak: The Markets dropped by more then 90% between its high
of 1929 and the low of July 1932.

Synopsis:

• The influx of easy money had made a great case for rising consumer debt. Americans were
buying stocks of listed companies against borrowed money. The avenues of consumption
encouraged people to spend more then the loan relying on the investment to generate a return
sufficient enough to repay back the whole loan as well as the interest. The development of new
products led to an unprecedented consumption of luxuries.
• The learned economist Fisher observed that the main cause for the depression was the rising
debt of an average American. He further stated that "If "A" owes a million to "B" and "B" a
million to "C" and so on till we find "Z" who owes a million back to "A" the failure of "A"
would bankrupt "B" which may cause the bankruptcy of "C" and so on and so forth. Thus a
net debt of zero may bankrupt 26 millionaires!
• Fisher commented further that while companies issued shares the applicants recklessly borrowed
to apply for these shares. Thus there was a shift of debt from the collective (corporate) level to
the personal level.
• Marc Faber in his book Tomorrow's Gold argues that had the rate of interest been raised the
public's appetite to take on further loans would have been dented and the panic might not have
occurred.
• This hike in the rate of interest might have hurt the business to some extent but would have
prevented the crash from occurring .
• Behavioral finance indicates that the less an investor knows, the easier it is for him or her to be
swallowed in popular opinion (herd mentality). This behavior is a double-edged sword because
the ignorant investors are also easily spooked into panic. Both actions, joining and fleeing, have
very little basis in the quality of the news or the quality of the market.
• The Harvard Economic society, which had made negative forecasts in 1929, changed its outlook to
positive right before the 1929 crash adds Faber. This was accompanied by a more precipitous fall as
stocks and investment trusts suffered substantial bleeding in the next couple of years.
• Dr Marc Faber points out to striking similarities between the great depression of 1929 and the
present state of the US economy. He lists these similarities as
o Merger fever
o High leverage
o Easy Monetary Policy
o Presence of Foreign Funds
o Favorable labor conditions
o PC's vs. the Radios
o Software instead of Movie Companies
o Internet instead of Electric utilities
• The twelve-year worldwide depression ended only with the declaration of the world war. This
stands as the worst financial blow to the USA ever. Economists predict that the US economy is
currently on road to yet another 1929 like crash.
The Dot-Com Crash
When: March 2000

Where: Across the globe where ever technology and particularly Internet stocks were traded

Percentage Lost From Peak to Bottom: The NASDAQ Composite lost 78% of its value as it fell from
5046.86 to 1114.11.

Synopsis:

• The U.S. military created the Internet for its own use. During its inception the internet's
commercial usage was vastly undermined. In 1995 the Internet had an estimated 18 million users.
The kind of scalability this business could derive was beyond comprehension of even its initial
founders.
• In the initial years of its launch hype over lapped hope. Entrepreneurs were busy incubating
Internet start-ups as they mushroomed from garages to drawing rooms. The gain in stock prices
increased the investors' confidence. The price ticker running at the bottom of the CNBC channel
was deciding whether you were right with your investments or not.
• While all the newly floated web sites generated viewerships they lacked a strong revenue model.
Investors were therefore betting on the premise that if you can have eye balls and web site hits
you will have revenue to back it up some day - but when was the question.
• AOL traded at a Pe of 305 times earnings while its peer IBM traded at 28 times. Simply put the
market was placing a greater degree of confidence on AOL then it did on IBM.
• AOL and Amazon were the better quality Internet plays . For each of the AOL's and Amazons
there were dozens of start up ideas that offered shares to the public without having a definite
revenue model.
• Stocks sold on ideas and as investors chased one stock after another. A new tool for evaluating
internet companies was identified - evaluate companies on the basis of web site hits and eye balls.
People talked about a market cap to eyeball ratio.
• Big ideas sold more then business plans. The new buzzwords were eyeballs, web site hits,
networking, information technologies, Internet, consumer-driven navigation, tailored web
experience. This hollow twist to investment analysis changed the normal way of evaluating
companies.
• You could not evaluate these companies on PE because they said the earnings would grow
exponentially and the PE was artificially enlarged. The discounted cash flow statement could not
be made because not even the promoters them selves were unsure about how their cash flow
models would look like. These companies could not be evaluated on market cap to sales basis since
the market cap was bid in some cases several hundred times over the sales.
• The IPO's of Internet companies emerged with amazing frequency It swept the entire spectrum of
global investors into a euphoria. Investors were blindly grabbing every new issue without even
looking at a business plan. Satyam Computer a leading IT services company in India bought a
website portal for Rs 500 crores.
• The market had to give way finally and it did. Some people had to identify the emperor without
clothes. As companies reported losses a few folded outright within months of their offering. In 1999
the US market saw 457 IPO's, most of which were Internet and technology related. Of those
 117 doubled in price on the first day of trading. In sharp contrast the year 2001 saw a meager
76 IPO's with none of them doubling on the first day of trading.
• Many argue that the dot-com boom and bust was a case of too much too fast. Companies that could
not decide on their revenue models were valued at billions of dollars in anticipation for
profitable growth.

Benjamin Graham – Numbers Numbers and Only Numbers

Best Quote: “While enthusiasm may be necessary for great accomplishments elsewhere, on
Wall Street it almost invariably leads to disaster”

What would Graham have bought in India ? Probably nothing except a few stocks where the
market value of holdings exceeds the market cap some thing like a Tata Investment.
Benjamin Graham was the only investing legend who ignored the subjective aspects of equity
analysis. Graham was never interested in meeting managements and knowing what they were
capable of doing or not doing. He never looked at a company's product pipeline nor concentrated
on anything else. All he saw and studies were hard core numbers - the Balance Sheet. He wanted to
buy cheap, discarded and under valued assets. He was fascinated with numbers and operated on
the premise that financial numbers capture every thing that an investor ought to know. He was
brutally shaven off in the 1929 crash.Later on he developed a theory that the prospects of a company
cannot be determined. He therefore advised investors to look back wards rather then forward. he He
encouraged investors to look at the operating history for the past 7 years . It was certain that
Graham was not looking at any of the companies in the new sector. In 1934 he published a book
titled “Security Analysis” which remains an investment classic till date. In the early 1950's
Warren Buffet was amongst his team of research analysts trying to decipher the investing
skills of the master.

Predominantly a man who saw numbers and ignored perceptions Graham had a very unique personal
life His second wife was his secretary and the third an employee. In fact he spent the last few years
of his life with a woman who was earlier involved with one of his sons.

One of Graham's basic investing rules was to compute real earnings of a company. His definition of
real earnings was dividend paid adjusted with increase (decrease) in the net asset per share –
which usually appears as the change in earned surplus including voluntary reserves.

Graham stressed the diversification mantra. His basic premise was to avoid having concentrated
portfolios . Since he ignored the subjective aspects of investment he wanted to buy companies
almost for free. While the idea looks good in theory it is actually hard to find such companies in
actual practice though. Graham backed his theory by the “Cigar butt” analogy. He stated that
cigar buts that are thrown on the ground are always good for a few puffs. Similarly investors
should look for discarded companies possessing a good turnaround prospects.

Graham professed that investors should buy companies when the current situation is
unfavorable, the near term prospects poor and the low price fully reflects the current
pessimism . Investors he added focus on the long term picture and ignore the daily quotations that
“Mr. Market” provides. He suggested treating the market as an insane partner who provides
daily quotes depending on which side of the bed he got up from. Clearly it should suit the
investor to buy shares when “Mr. Market” displays more insanity then otherwise .

Graham advised Investors to keep their equity exposure within 75% of their net assets. For the the
more adventurous investors a 100% exposure to equity could be considered in case he meets the
following guidelines:

o Keep enough cash to take care of 12 months of your family expenses

o You wish to invest steadily for at least 20 years into the future
o Survived the bigger bear markets – maybe the 2000 tech bubble
 o Did not panic and sell stocks but actually bought more stocks of solid stable companies
as prices continued to slide during the above bear markets
o You understand and are able to differentiate between hope and hype.

Key learning:

o Buy Stocks trading at two- thirds of their Net current assets and sell them as they approach
their net current assets. Graham does not account for the fixed assets and recommends
deduction of all liabilities while computing net current assets.
o The Earnings yield (inverse of the PE ratio) should be twice of that of a “AAA” rated bond.
In other words if the interest rate on a “AAA” bond is 5% the earnings yield should be at
least 10% or the PE ratio of the stock should be 1/10% = 10.
o The Company’s debt to equity ratio should not be more then 1. For computation debt should
include preferred stock
o The dividend yield on a stock should not be less then two third of a “AAA” bond yield.

What to look for before Selling?

o Sell after the stock moves up 50%. Sell after two years if it does not move up by 50%.
o Sell if the company stops declaring dividends.
o Sell if the earnings decline or the stock moves up by 50% over the new target-buying price.

Clearly in today's environement of overvalued asset classes it will be very difficult to find a
stock on the Benjamin Graham way of Investing. Perhaps the 1929 fall shook him so much that
he turned risk averse in the strict sense.

Warren Buffet The Schumacher of Investing

Best Quote: Never count on making a good sale. Have the purchase price be so attractive that
even a mediocre sale will give good results
Warren Buffett is by far the most successful investor of all times. He buys businesses that are simple
and easy to understand. Once a business has been bought the time to sell it is “almost never”.
Warren Buffet tries to look at stocks as pieces of part ownership of businesses. Buffet rarely
follows the minute-to-minute fluctuation in stock prices and prefers to stay in the small town of
Nebraska. Buffet’s holding period often extends into decades and this particular quote makes for a
very interesting reading. In a a recent letter to the shreholders of his company, Buffet wrote:

“We bought some Wells Fargo shares last year. Otherwise, among our six largest holdings, we
last changed our position in Coca-Cola in 1994, American Express in 1998, Gillette in 1989,
Washington Post in 1973, and Moody’s in 2000. Brokers don’t love us”

Buffet argues that the key to investing is not assessing how much an industry is going to affect
society, or how much it will grow, but rather determining the competitive advantage of any given
company and above all the durability of that advantage.

Key learning:

o Be focused and buy concentrated portfolios – they perform better. Buying two stocks in
every sector will help you create a zoo not a portfolio. A person who diversifies is the one
who is unsure of his investments. Buffet once put about half of his wealth in a single stock
“American Express” when he believed that the company was into a one off problem.
o Buy what you see and understand. Buffet never bought a single technology company in spite
of being a very good friend of Bill Gates.
o Buy businesses not stocks. Buffet advocates investors to be and think like passive a owner of
that business
o Understand the Margin of Safety and the Circle of competence. These are Buffet's favourite
words. Do not be a jack-of-all-trades buy stocks of businesses that you understand.
o Employ the magic of compounding
o Investing is a full time job (24x7x52). If you can go to a dentist for your teeth, cobbler for
your shoes, barber for your hair then why can’t you go for an expert for your wealth.

Piquant styles:

Separated bottle corks from the garbage so that he could know which company sold more cold
drinks

o It took him about 2 years to figure out that his room was painted in his absence as he just
looked at books inside the room.
o Although he owns a private jet he preferred to stay away from Wall Street in a small town
and declined to invest in a company whose CEO took out a brand mew letter pad to explain
the company’s plans
o He once invested in a company located on the seashore which had only three sides of its
building painted. The side facing the sea was left without paint.
 o When his wife spent US $ 15,000 on home furnishing his first comments to a friend were”
You know how much is that worth if you compound it for 20 years.

Key learning

Business

Simple understandable – mostly buy what you see category

o Consistent operating history

o Favorable long-term prospects
o Strong Franchises with pricing power. Buffet wanted to hold on to companies that were
surrounded by a moat so that your competitors could not squeeze you on prices and profits.

Amongst Buffet’s favorite businesses were Banks. Media and Consumer related stocks. Buffet liked
T.V stations as he thought that the fixed capital requirements were low, companies operated with
little inventories and negative working capital and had a very high profit margin on sales.

Management.

o Trust worthy managements deserve premium. They should be clear and forthcoming
o Avoid companies with managers following lavish and extravagant styles

Financials

o Look for High Return on Equity (RoE)

o Look for high and stable profit margins

Markets

o Use conservative earning estimates and the risk free rate of return as the discount rate
o Valuable companies can be bought at attractive prices when investors turn away.

Companies to avoid:

o Buffet avoided investing into companies that required a high degree of research. He did not
buy technology and pharmaceutical companies.
 o Buffet was apprehensive about retailing companies his concern – A company could report
good numbers year after year and then suddenly go bankrupt. Buffet avoided investments
into aircraft carriers as well.
o Companies that had a very long inventory cycle like farm (agricultural) businesses should
also be avoided.
o Buffet advised investors not to put money into Cash guzzling businesses but instead look for
businesses that generated free cash flows year after year.
o Commodities were an absolute no - no. Buffet stated that agricultural commodities in
particular are dependent upon the mercy of weather, which adds another twist to computation
of the probability of an event.

Peter Lynch – Buy what you see

Best Quote:If one could tell the future by looking at Balance Sheets then Accountants and
Mathematicians would have been the richest people in the world.

What would have Lynch bought in India? ITC, Maruti, Hero honda, Bharti Airtel, Pantaloon
Retail, TV-18 and the likes.

Most Fund Managers are known for their investing styles rather then the investments that they make.
Peter Lynch is one of them. As the fund Manager for the Magellan fund Lynch grew to fame for his
"Buy what you see "school of thought". An initial Investment of US $ 10,000 would have grown
over to US $ 2.50,000 in the 13 years that Lynch managed the fund. His annual rate of compounded
growth averaged 29.2%. The greatness of Lynch lied in his simplicity. He was one of the few people
from the Fund Manager fraternity who taught and practiced the KISS (Keep it Simple Stupid)
principle.

Most often people invest in sectors and industries that they know little of. For instance a Doctor
could be investing into a technology company while a software engineer could be looking at
pharmaceutical stocks. Lynch often remarked “Your investor’s edge is not something you get from
Wall Street experts. It’s something you already have. You can outperform the experts if you use your
edge by investing in companies or industries you already understand”

Although he held more then 1400 stocks in his Magellan fund Lynch advised people to hold stocks
of as many companies as they felt comfortable with. For instance he advised investors to hold fewer
well researched stocks rather then own a complete index replica as such.

His advise on the number of stocks investors should hold was also simple. “Owning stocks is like
having children – don’t get involved with more than you can handle. The part- time stock picker
probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There
don’t have to be more than 5 companies in the portfolio at any one time”.

Key learning:

o Small Market capitalized companies - Lynch loved small emerging businesses with strong
balance sheets,. His extraordinary returns in La Quinta Inns came at a time when the
company was in the initial years of development He argued "Big companies don't have big
stock moves you’ll get your biggest moves in smaller companies."
o Fast growers - Among Lynch's favorites are companies whose sales and earnings are
expanding 20% to 30% a year. He cautions investors from looking at companies that grow
more then 30% every year. Companies growing at 50% to 100% are bound to falter and
crack. It is therefore imperative to view very high growth ideas with a sense of suspicion.
o At the same time, he advised investors to look for slower-growth businesses selling at a truly
great price.
o Dull names, dull products, dead industry - Lynch loved good managements in simple
mundane, colorless businesses. His arguments were that nobody creates excess capacity in
dull boring industries and when you can find a winner there it makes sense to jump in.
o Lynch loved boring businesses with boring company namesL. Peter Lynch writes about both
in One Up on Wall Street. No self-respecting Wall Street broker could recommend absurdly
named unknown companies to his key clients. And that left the greatest money managers an
opportunity to scoop up a truly solid business at a deep discount.
o Spin Offs - Lynch's dream stock at Fidelity Magellan was one that hadn't yet attracted any
attention from Wall Street. One-way Lynch recommends finding these companies is to buy
spin-offs. For instance, after being spun off, Toys "R" Us went on in relative obscurity to rise
more than 55 times in value. Lynch also made a fortune buying into the funeral and cemetery
business Service Corp, which had no analyst coverage.
o Insider buying and share buybacks: Lynch loves companies where the senior managements
bought stocks of their own companies. A combination of insider buying and aggressive share
buybacks really piqued his interest. "Buying back shares," Lynch writes, "is the simplest,
best way a company can reward its investors."

Lynch ignores conscious asset allocation between various asset classes. He says that market players
may have 50% of their portfolio in cash at market bottoms. When the market decides to move up
they could miss most of the move.

Lynch was the proponent of the PEG theory. As long as the PE of a company was lower then the growth
rate that it expected to generate Lynch would have advocated a buy on the stock.

While making investments Lynch advised people not be try and catch bottoms. If you liked a
company he argued take a small position and add it up as you see further visibility in earnings
growth. Lynch stated that “time is on your side when you own shares of superior companies. You
can afford to be patient – even if you missed Wal-Mart in the first five years, it was a great stock to
own in the next five years also”. In this connection he presented a very interesting statistic.
 Time and not Timing is the Key
S&P Returns for 40 years since
Market timing strategies
1954
Invested all the time 11.4%
Missed the ten most profitable months 8.3%
Missed the forty most profitable
2.3%
months

Lynch cautions investors to do away with weekend thinking, predicting the future course of the
economy and debating on the movements in interest rates and other macro economic variable. His
advise on this count was “Nobody can predict interest rates, the future direction of the economy, or
the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the
company you are invested in.”

And Finally Lynch says that several small gains make a one very large move. Three 30% gains
equals a four bagger is his advice to investors.

The Thirteen Commandments - Gospels from Jesse Livermore

1. Never act on tips.
2. Never buy a stock because it has had a big decline from its previous high.
3. If a stock doesn't act right don't touch it; because, being unable to tell precisely what is wrong, you
cannot tell which way it is going. No diagnosis, no prognosis. No prognosis, no profit.
4. Don't blame the market for your losses. Never add to a losing position. A losing position means you
were wrong.
5. Stocks are never too high for you to begin buying or too low to begin selling. But after the initial
transaction, don't make a second unless the first shows you a profit.
6. Always sell what shows you a loss and keep what shows you a profit.
7. Don't argue with the tape. Do not seek to lure the profit back. Quit while the quitting is good--and
cheap.
8. There is only one side to the stock market; and it is not the bull side or the bear side but the right
side.
9. The speculator's chief enemies are always boredom from within.
10. A man must believe in himself and his judgment if he expects to make a living at this game.
11. Bulls and bears make money, but pigs get slaughtered
12. Markets are never wrong. Opinions are!

Concentrated portfolios – The Best way to hold stocks.

A diversified portfolio tells you two things. One is, your standards are falling. Or the other thing, the markets
are incredibly cheap. So yes that itself gives you discipline. If you are finding it incredibly difficult finding your
dozen good ideas, again it tells you that either your standards are way too high, so you are an academic or the
market is probably overvalued at this point – Vinod Sethi Fmr Fund Manager at Morgan Stanley

The Robert Hagstorm Study

Results of Concentration

STEP – 1 The Different Sample Size

Computer Randomly assigns from 1200 companies, 12000 portfolios of various sizes. For 10 years returns .
3000 portfolios containing 250 stocks each
3000 portfolios containing 100 stocks each
3000 portfolios containing 50 stocks each
3000 portfolios containing 15 stocks each

STEP – 2 Results of the Sample analysis

Stocks
Best returns Worst returns Out perform
250 16.0% 11.4% 63/3000
100 18.3% 10.0% 337/3000
50 19.1% 8.6% 549/3000
15 26.6% 4.4% 808/3000
Gp 13.8% Average
S&P 15.2% Real

The Final Answer

Sample Chances of outperforming the Number of stocks that outperformed the

market. market
With a 15 stock
1-in-4 (898/3000)
portfolio.
With a 250 stock
1-in-50 (63/3000)
portfolio.
Random returns are better with a focused portfolio. (Hence, Stock Selection)
Trading Costs and taxes are ignored but they would lower returns
 (Study from The Warren Buffet Portfolio by Robert Hagstorm)

Stock Computational Tools

Beta

A measure of the volatility of a stock relative to the overall market. A beta of less than one indicates lower
volatility than the market; a beta of more than one indicates higher volatility than the market.Generally Consumer and
utility stocks have low beta compared to cyclicals and industrials.

Book Value

It shows the historic cost of the assets as reduced by the depreciation . It is significant for evaluating Banking
company stocks. Stocks of companies holding large blocks of land and other hidden assets are evaluated on this
basis. It does not make sense to look at book value for companies in high growth businesses.

Shareholders funds
_________________
No. Of Equity shares

Cost of Capital

This is the cost of borrowing funds from the market. The ROE and the ROCE should be more then the cost of
capital or else it would make little sense for the company to borrow funds . For stocks in the emerging markets the
cost of capital should be 300 to 400 basis points above the risk free rate of return .

Risk free rate of return + Equity risk premium.

Debt Equity Ratio

Long-term debt divided by shareholders' equity, showing relationship between long-term funds provided by
creditors with respect to the Shareholders funds. A high Debt Equity ratio indicates high risk while a lower ratio
may indicates lower risk . Short-term debt is not included as long as cash is greater then short-term debt. As equity
increases relative to debt, the company becomes a more attractive investment. Finally, bond debt is preferred to
bank debt because bank debt is due on demand. Companies that repay back debt experience PE expansion
compared to companies that take on debt.

Long term loans

_________________
Shareholders Funds
Delta

The delta factor is calculated by dividing the amount of price difference of the option value by the amount of
price difference in the underlying stock. For example if the price of the stock option increases by 2% when the
stock price went up 4%, you would have a delta factor of 0.50 arrived at by dividing 2% by 4%. This means you
would expect your option to increase at half the rate of the stock

Dividend yield

This is the current yield on a stock. Dividend paying companies have in built bottoms. When the stock prices fall
too much their dividend yield becomes attractive enough for existing investors to hold on as well as for new
investors to get in. This is a basic criterion for a value investor Stocks that pay dividends are obviously favored
over stocks that don't . Dividend paying stocks are likely to fall less in an economic downturn As stock prices fall
with no fall in dividends, the dividend yield rises attracting new investors. Finally, if you do buy a stock for
dividend , you should make sure that the company has a history of paying the dividend in both good times and
bad.

Dividend per share

________________
Market Price

Discounted cash flow statement

Discounted Value of free cash flow that a business generates during a particular period of time. Companies
embarking on a major Capital expenditure program will experience reduced free cash flow and lower
valuations. A rise in interest rates increases the cost of capital and also reduces valuations Most of the analyst
fraternity uses this concept. The risk free rate is used as the discount rate. This evaluation tool is helpful only for
evaluating stable businesses rather then high growth businesses .

Earning per share (EPS):

This is the net income divided by the number of shares outstanding however; both the numerator and denominator
can change depending on how you define "earnings" and "shares outstanding . The E.PS as an absolute figure
means nothing and is significant only when viewed in relation to the price of the stock.

Net Profits
_________________
No. Of Equity Shares

Enterprise Value

The sum total of market cap and debt. Enterprise value for cash rich companies is market cap as reduced by
cash. During bear markets smart Investors are able to spot a number of companies that are available at zero or
negative enterprise value. In 2002 Trent was available at Rs 60 when it had Rs 100 as cash on its balance sheet.
The stock has been a multibagger since.

Market Capitalization + Debt

EVA

TEconomic Value added is the excess of ROCE over the cost of capital . Companies with higher EVA's are able
to generate higher PE's and are generally wealth creators compared to companies that have a low or negative
EVA.

(ROCE – Cost of capital) Capital employed

Free Cash flows

The amount of cash left in a company after all expenditure both revenue and capital has been accounted for. This is
also known as the net addition to cash. Free cash flow per share = Cash earnings - capital spending. Companies
that generate substantial free cash flows make for very good investments.

Growth in Stock Price vs. Growth in earnings

A dangerous signal is generated when the stock price of a company increases faster than its earnings.
Invariabily this wleads to a higher PE multiple and makes the stocks liable for decline. Generally it is better to
ivest into businesses their earnings growing at an equal pace to their stock prices.

Inventory Growth vs. Sales

Inventories that are “piling up” and are not sold signal poor business . If the growth in inventories is greater than
the growth in sales, then the company's products are piling up, leading to a potential decline in the price as this
information spreads.

Market Capitalization

The market cap is the amount of money that the acquirer would need to buy back all the outstanding shares .
In case of absurd valuations the market cap reaches stupid levels. During the 2000 tech boom Himachal
Futuristic sold at a market cap of Rs 20,000 crores .Multibaggers (stocks that go up a number of times)
generally have a very small market cap to start with. Companies with a market cap of more then US $ 1 billion
are classified as large caps, between US $ 250 million to 1 $billion as mid caps and less then 250 million as small
caps. Read the section on market cap argument

Market price x No. Of Equity shares

Market PE

Generally the weighted average of all the 30 stocks in the BSE Sensitive Index is termed as the market PE.
The Market PE is inversely related with interest rates. This means that if interest rates go up the market PE
contracts and vice versa. Falling interest is a rate is bullish for markets while rising interest rates are a bearish
signal.

1
___________________
Risk free rate of return

Market Cap to Sales

It is the number of times the sales exceeds the market cap. For companies in growth businesses the market cap to
sales could be about 3 times whereas for companies in low growth businesses it should be equal to 1 .The sales
number are the most difficult to fudge and therefore the market cap to sales is a more reliable indicator in corporate
analysis. In the 2000 technology bubble Infosys traded at a market cap to sales of more then 100!

Market Cap
___________
Sales

Overpriced stock

There are many ways to indicate an overpriced stock but generally a stock will be categorized as overpriced
when its PE would exceed the sustainable growth rate . For instance if Hindustan Lever Ltd (HLL) trades at a PE
of 25 and investors expect the company to show an earnings growth of 10% over the next few years the stock would
be considered over priced. Companies in a turnaround mode merit investment even while they have an
indefinite PE For small market cap companies and companies that have a lot of inherent value the PE could be
less then the growth rate.

PE > sustainable growth rate

PEG

This is known as the Price earnings to growth ratio. It should be less then equal to 1 Growth in Earnings vs. the
P/E Ratio . The ratio will be lower for slow growers and higher for fast growers. An important indicator that is
related to

PE
________________
Sustainable Growth

Percent of Sales

If a company appears attractive because of a particular product, one must see how much that product
contributes to the overall sales of the company. If the percentage is low, then even a very successful product will
not mean much to the company's bottom line. In the technology boom many people bought L&T and Siemens
hoping to make money from their software divisions but their stock prices hardly moved since the weight of
software was a very small part of their total sales.
Price Earnings (PE)

This is one of the most widely used tools in sizing up stocks. Simply put, it is how much investors are willing to pay
for a rupee of the company's earnings. It is also termed as referred to as a "multiple." When you calculate a P/E
based on the past year's earnings, the P/E is called "trailing." Another way to determine a P/E is to substitute future
earnings projections. This is the "forward" P/E (also referred to as the "anticipated" P/E). Another way of looking at
the PE This as the number of years it will take to earn back the initial investment .
Market price
____________
EPS

Price to BookValue

This is used mainly for Banking (where the book value is adjusted for Non performing assets) and old economy
stocks. It is defined as the number of times the market price equals the book value of the stocks.

Market Price
_____________
Book Value

Profit margin

The profit margin after taxes = (Sales - all costs including depreciation, interest and tax) /total sales. As profit
margins vary widely across industries, comparing profit margins among different companies make sense only within
the same industry or to industry averages. The company that has the highest profit margin is also the lowest cost
producer. Margins can be increased either by increasing sales or by decreasing cost . Since Selling price is
seldom in the hands of the company it increases margins generally by reducing costs. The company with the largest
profit margin will be the company that is most likely to survive in an economic downturn.

Return on Equity (RoE)

Return on Equity (RoE) is an indicator of how efficiently the shareholders funds (Equity) are being used .
Companies having a higher RoE tend to be wealth creators and companies having an RoE of less then 15% tend
to be wealth destroyers . Normally higher the RoE higher the PE . Companies that are engaged into commodity
businesses have lower RoE's compared to the ones that are engaged into high growth businesses. As with the PE
Companies that are in the initial stages of growth and are available at small market caps or the ones, which are
yet to see the earnings hit a peak, can be bought in spite of having a low RoE. Commodity companies exhibiting
very high RoE's are a sign of danger since that would encourage new entrants to rush in and push prices down.

EPS
_________
Book Value

Return on Market Cap

The percentage that profits that can be earned if an investor buys all the shares from the market. It is
theoretically equal to the inverse of the PE (1/PE)

Net Profits
---------------
Market Cap

Under valued stock

For an undervalued stock the PE should not exceed the growth rate . For instance if Hindustan Lever Ltd trades at
a PE of 25 and investors expect the company to show an earnings growth of 40% over the next few years the stock
would be considered under priced. Similarly for companies having inherent value either in terms of cash,
property or other hidden assets or companies that have a very small market cap the PE to growth can be
ignored .

PE < growth rate

Infosys in March 2000 was still a very good company but at a bad price

Year Price E.P.S P.E Market Cap

March 1998 110 3.67 30 3,180
March 2000 3482 11.60 300 93,836
Change 31.65 3.16 10 31.6
(times)
March 2000 3482 11.60 300 93,836
March 2005 2282 65 35.1 61,500
Change 65.53% +5.60 00.12 65.53%
(percent)

Between 1998 and 2000 Infosys experienced a PE expansion of 10 times and an EPS expansion of 3.16 times. This
sent the stock 31.6 times higher. Since the 100% growth rate could not be sustained the stock's PE was butchered
from 300 times to 35 times in the next 5 years. Even while the EPS rose by more 5 times the stock price failed to take
out its previous high and actually fell even while the earnings per share went up more then 5 times.
 Cyclical Stocks – Never a Long term Bet

• Cyclicals should be bought when the Price to Earnings (PE) is at its maximum and sold when the PE is
at its minimum. In 2001 Tata Steel traded at a PE of 50 times. After having gone up 10 times and well into
the top of the steel cycle it trades at a PE of 5 times.

• The problem with steel, aluminum, cement and other Cyclicals is thatas the price of their end product rises
a number of projects that were closed down earlier become viable. This releases a gush of new supply.
Rising commodity prices encourage entrepreneurs to start green field projects Banks and Financial
Institutions that were earlier not disbursing loans become eager to advance as project viability increases

• When these companies start hitting their lows they should be evaluated on market cap and the
replacement cost basis. In 2001 Tata Steel traded at a PE multiple of 50 times with a Market cap of Rs 2000
crores (US $ 500 million) and is presently valued at (US $ 5 billion)

• In times of higher profitability (increasing operating margins) rising RoE's and lower PE's cyclicals are
most probably nearing their top.

• If one were to invest in cyclical commodities it is better to keep track of the London metal Exchange ( LME)
prices. A crash at the LME metal prices precedes a fall at the domestic bourses.
 • For commodities one has to keep an eye on the Govt.'s import / export policies. A rise in import duties
never gets a stock a higher multiple. This is because the market is never sure whether this import duty
would not be reduced during the next budget.

• Over a period of 10 years cyclicals have not delivered more then the market rate of return. See Market
Cap Chart.

MANAGEMENT FAIR OR FOUL

• Promoters who keep diluting equity. In Corporate finance studies the cost of equity capital is taken to be
higher then that of debt. It therefore makes sense for companies to take on debt for further growth and be very
conservative with equity dilution.

• Promoters who issue warrants to themselves at substantial discounts to market price.

• Check whether the company sticks to its guidance . Mastek and Polaris are two Indian software companies
that have often deviated from what they promise. While Mastek and Infosys were incorporated at around the
same time the latter trades at a market cap of more then 100 times the former.

• Whether the stock price moves just about a fortnight before the unexpected news (e.g. acquisition, hefty
dividend etc). Investors will have to distinguish between what is known as mosaic theory. This theory
assumes that the analyst committee can forecast some of the corporate actions. Stock specific news that hit the
market after the stock has been ramped up is a bad sign indicating that the insiders knew of this development.
E Serve and Digital Software were up quite a bit before the company came out with their open offers.

• Companies that buy back their own shares only to reissue them later at huge premiums are again playing
foul on small investors. Bharti Airtel did this but investors have benefitted since then. there is nothing easy in
this business!

• Companies that buy back their own shares are always a great bet on the bourses

• Companies having good managements have a large dividend pay out ratio.

• Decline or rise in promoter holdings. After the 2000 tech debacle the promoter holdings in companies
like DSQ Software and Himachal Futuristic saw a continous decline.
 • A very high Tax Payout Ratio is a signal that earnings are for real and the management genuine.

• A very large Institutional Ownership means that the company is well researched and prima facie
management concerns are not there. But companies that have large institutional ownership do not generate
above market returns.

• The CEO position. Whether it is within the family or outside?

• Educational Qualifications of the top Brass. It has been my personal observation that companies that are
headed by graduates from IIM and IIT perform very well. They also follow a very high level of
Corporate Governance. Alternatively Companies headed by Accounting professionals are unable to
perform that well.

• Problems in a company are like cockroaches in the kitchen. You will never find just one – Warren Buffet

Buffett : The compensation to what management can control and have an impact on. At Geico, for instance, we
look at growth and profitability of seasoned business. (New business loses money for awhile.) Don't pay for the
wrong things, or for what management can't control. I think it's ironic that energy executives are being paid well
recently as oil prices have gone up, but then go up and testify before Congress that they don't have anything to do
with high energy prices. Energy companies should pay management based on finding costs. If a company can
achieve and maintain lower-than-average unit finding costs over an extended period, say 3 to 5 years, then
management should be paid well.

We look for managers that have a passion for their business. We've had terrific luck with entrepreneurs who love
their businesses like I love Berkshire. They'll tell me to butt out if I'm going to screw it up. They are part of Berkshire,
but guard their businesses jealousy.

We got a book from an investment bank from someone who bought a business a few years ago [and now wanted to
sell it]. The business was a piece of meat to them. What are the odds that they didn't doctor the books?

[I look for people who] have a lot of love for their business. There can't be a company in the country, if you could
measure passion for the business, no-one would come close [to Berkshire].

Charlie Munger: What matters most: passion or competence that was born in? Berkshire is full of people who have a
peculiar passion for their own business. I would argue passion is more important than brain power
Re-Rating. PE Expansion

In the initial phases of growth the market does not believe the growth that the Period - 1
company is experiencing. Also the stock remains unrecognized Therefore the EPS 15
PE multiple is bid up at less then the growth rate. Let us assume that a PE 10 Growth 40%
company with a growth of 40% is given a multiple of 10 for an EPS of Rs 15. The Market Price Rs 150
market price is Rs 150

One year later as the earnings rise to Rs 21(15+ 40% x 15) the growth of the Period- 2
company is assumed real and consistent. As the stock gains recognition and EPS 21
more coverage it starts getting a higher multiple of say 40 times . The price PE 40
would suddenly shoot up to Rs 840 Growth 40%
Market Price Rs 840

Stock goes up 4 times because of PE expansion and 40% because of earnings growth

De-Rating. PE contraction
Once the stock has been recognized and the market convinced about the growth Period - 2
rates the PE multiples move ahead of the growth rates. For instance during the EPS 21
2000 technology boom Infosys was valued at more then 100 times its earnings PE 40
since the company was delivering a growth of 100% year after year. Since Growth 40%
businesses today are characterized by free entry and free exit growth rates in the Market Price Rs 840
longer term would never exceed 30% at most

Let us assume that in the example given above the company's growth rates tapers Period - 3
off to a more realistic 20%. These changes in growth rates do not happen year on EPS 25.2
year but still the market responds to this change earlier then they are out in PE 15
the public domain because of this the PE multiple of the company will Growth 15%
contract and due to over ownership problems the PE normally contracts to Market Price Rs 378
less then the growth rate “g”.

Stock comes down about 60% because of PE contraction and goes up 15% because of earnings growth. Net net it
is down by a huge margin.

THINGS TO LEARN EARN FROM PAST

In 1995 Infosys traded at a market cap of about Rs 414 crores the growth was always looked upon with disbelief.
The PE was less then growth and the Management was professional. At the time of IPO Narayan Murthi had great
difficulty in finalizing a merchant banker as nobody wanted to handle a software company? Initially there were
concerns that all the growth would stop post the year 2000 (after the Y2k projects got over ) the company
continues to show growth year after and will employ more then 50,000 software professionals this year..
 •
C

•
E

•
L

•
N

•
P

•
p

•
E

•
P

•
L

In late 2003 Nagarjuna Construction traded at Rs 90 with a • Comfortable PEG

market cap of Rs 100 crores . The PE was less then 5 times • Low Market Cap
had a book value greater then the price and a dividend pay • Old Sector with structural
out ratio of 3%, which protected the down side. While the • shifts in dynamics
company was in safe hands as there was nothing to believe that • Phenomenal growth
the management lacked integrity construction stocks lacked • prospects
flavor. The spate of National Highway projects created • Management concerns
demand for the sector and once it was recognized the stock is • Professional management
up more then 15 times.6 times. • Unorganized nature of the

• Construction Industry
 In 2003 Pantaloon at a market cap of Rs 85 crores and sales • Low PEG
of Rs 450 crores trades at a P/E of 8 at Rs 50.the • Low Market Cap
Management was confident of 50% plus growth but nobody • New Sector
took the promoter seriously. There was a very low Institutional • Good growth prospects
ownership. Except for the subjective fear of an unknown • Unknown management
management things looked all right. After all Narayan Murthi
and Dhirubhai were also first generation promoters. Analysts • Lack of professionals
still raise concerns on the company's inventory accounting
policies but the stock is up more then 40 times in 3 years.

In 2003 Bharti Airtel traded at a market cap of Rs 4,000 • New Sector

crores. A loss making company with Prospective threat from the • Good growth prospects
Reliance Infocom stable, cut throat competition in terms of • Unknown management
billing rates, Bharti Televentures had nothing going for it inn • Company controlled more
terms of news flow. The company continued to report • then 30% of India 's mobile
scintillating growth quarter after quarter. Investors had seen • telephony market
how China Mobile and China Unicom had become billion • Mobile telephony companies
dollar businesses
• had gone up manifold in

other emerging markets

DIVIDENDS WATCH THE FINE PRINT

• If the company's ROE and ROCE are above the normal rate of return the company should use the
excess cash to expand business rather pay off dividends.

• In case the opportunities for business expansion are limited and not forthcoming then one should not be
invested in that stock because the market pays for growth only

• Companies that pay off a one time hefty dividend accept that there is no opportunity for expansion for
at least a couple of years down the line . The Markets may take the stock up but after a while the price
retraces.

• History shows that dividend yield acts only as a floor to a stock price but is never powerful enough to
create market cap.
• “Far more stocks giving a bad performance come from high dividend paying companies rather then the low
dividend paying group . An otherwise good management that increase dividends and thereby sacrifices
worthwhile opportunities for reinvesting increased earnings in the business is like the manager of a
farm who rushes his magnificent livestock to the market the minute he can sell them rather then raising
them to the point where he can get the maximum price of above his costs. He has produced a little more
cash right now but at a frightful cost” – Philip. A. Fisher

Sustainable Advantage – The important tool to shareholder value

General Special

Physical resources : A steel company should have Strategy : Managements that follow good long term
its own Iron ore mines. startegies thinking ahead of the curve are always
able to create share holder value.

Locational advantage : Either the company has Technology: Companies that spend on technological
to be located closer to its raw material source or upgradation are able to maintain their position in the
the market in which it seeks to operate. market. ompare a Hindustan Motors with a Maruti.

Human Capital: This is the most important facet of

Economies of Scale: WIth increasing
capapcity the company generates economies of
scale that push down costs even lower.
Tariff : Businesses which survive on tariff and
protection measures are never unable to create
share holder value.
Entry : Buffet called it the ultimate advantage.
" If you gave me US $ 100 billion and say take
away the soft drink leadership of coca cola in
the world I'd give it back and say it cannot be
done"
Cartels: These are agrements amongst sellers
not to sell below a certain price or to hold back
supplies. Generally the life of cartels is very
difficult to envisage and therefore they enjoy
lower PE's.
business activity. My personal preference is to look
for IIT and IIM Graduates in the top level positions.
Culture : Companies that are able to integrate
themselves witrh the local culture are able to
maintain and generate that sustainable advantage.
First Mover: Companies that are first mover in
their Industries and are able to hold on to that
advantage enjoy better multiples and also hold on to
their advantage
Entrepreneurship and Risk taking
And finally it is the entrepreneur that makes and
creates that sustainable advantage.
The PE drivers

Internal factors:

• Financial History – A longer operating history gets a company a higher PE compared to unknown
businesses.

• Barriers to Entry – Companies that operate in Industries having barriers to entry are given a higher multiple
then the ones operating in an environment having no barrier to entry.

• RoE and RoCE – A higher RoCE and RoE indicates operating efficiency and generates a higher multiple
compared to companies having lower RoE and RoCE.

• Free Cash Generation – Businesses generating a greater amount of free cash have higher PE's compared to
cash guzzling operations.

• Critical Mass and Size – Larger companies having reached a critical mass get a higher PE compared to their
smaller peers.

• Corporate Governance – An honest Management adhering to ethics, morality and following clean and
conservative accounting systems will have a higher PE.

• Dividend Policy – Market loves dividends and companies that give out large dividends get a higher PE.

• Price Leadership – Corporations that have are price and influence the market price of the product gets higher
PE.

• Investor communication – Companies that embark on providing a great deal of information to their
shareholders and are bid up to higher multiples when compared to the companies that do not provide adequate
information to investors.

• Index component – Companies that are a part of the Index are given a higher multiple compared to
companies that do not form part of the index.

• Trading volume – Liquid stocks get higher PE compared to the illiquid ones.
Du Pont Analysis.
Return on Equity (RoE) = Net profit margin X Asset turnover X leverage

Net profit/ Equity = Return on Asset ( Net profit / Sales X Sales/Fixed Assets ) X Total assets/Equity

RoE = Return on Assets (RoA) X Total Assets/ Equity

Breaking the RoE into these three parts allows evaluation of how well the company manages its:

• Expenses,
• Assets
• Debt.

A manager has basically three ways of improving operating performance in terms of Return on Assets (ROA) and
Return on Equity (ROE). These are:

• Increase operating profit margins - Control expenses

• Increase capital asset turnover - Increase Asset Productivity
• Change financial leverage - Use debt capital for higher RoE as long as RoCE is higher then cost of
capital.

Each of these primary drivers is impacted by the specific decisions on cost control, efficiency productivity,
marketing choices etc .

Importance of Dupont Analysis

Any decision affecting the product prices, per unit costs, volume or efficiency has an impact on the profit
margin or turnover ratios. Similarly any decision affecting the amount and ratio of debt or equity used will
affect the financial structure and the overall cost of capital of a company. Therefore, these financial concepts are
very important to evaluate as every business is competing for limited capital resources. Understanding the
interrelationships among the various ratios such as turnover ratios, leverage, and profitability ratios helps
companies to put their money areas where the risk adjusted return is the maximum
 The Economic Value Added (EVA) – The most important and least talked about financial tool

The Economic Value Added (EVA) is a measure of surplus value created on investment.

• Define the return on capital employed (ROCE)

• Define the cost of capital as the weighted average of the costs of the different financing instruments used to
finance the investment.

• EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project)

When a company or a division has a negative EVA , it means that

• The firm or division has made poor investments in the past

• The capital invested in the division was mis-measured (over estimated)

• The operating income was under estimated

• The firm or division is at an early stage in the life cycle and has not hit its peak earning stages yet

o All of the above

o Any of the above

Assuming that a division has a negative EVA because of poor investments in the past, the right action to take is

• Shut it down or liquidate it

• Sell it
• Continue in operations
Growth rate. The one real thing to look out for!

A company is in a stable growth phase when

• It is growing at its ROE or the sector growth rate in which it operates.

• Its risk characteristics and leverage (Debt) resemble those of a stable growth company in the market.

All companies will become stable growth firms at some point

• Due to free entry and free exit no company can expect to maintain the super normal growth rates forever.
• Never factor in a more then 40% growth rate per anum. Over a secular long term period the growth
rate for the excellently run businesses drop down to a more moderate 20 to 25% and any rate of growth
higher then this cannot be sustained..
• The rate of growth is inversely proportional to the size of the company . After reaching critical mass a
large sized company tends to slow down a bit. That is when the stock takes a hit.

To estimate when a company will hit stable growth, you have to look at:

• The size of the company relative to the sector.

• The current growth rate of the company, RoE, operating margins . Companies on a high growth rate will
experience expanding margins and increasing to stable RoE's.
• The competitive advantages and barriers to entry that give the company its capacity for high growth and
high returns.

Increasing the length of High Growth Period

• Every company, at some point in the future, will become a stable growth company, growing at a rate
equal to its ROE or the sector growth rate in which it operates.
• The high growth period refers to the period over which a business is able to sustain a growth rate greater
than this “stable” growth rate.
• If a company is able to increase the length of its high growth period, other things remaining equal, it
will increase vlue .

The Brand Name Advantage

• Companies that are able to sustain their super-normal returns and growth because they have well-recognized
brand names allows them to charge higher prices than their competitors while maintaining/increasing
market share.
• Companies that are able to improve their brand name value over time can increase both their growth
rate and the period over which they can expect to grow at rates above the stable growth rate, thus
increasing value
 Investor Psychology: - Warren Buffet

There are no secrets to investing that only some select priesthood knows. Successful investing requires a quality of
temperament, not a high IQ. You need an IQ of 125, tops—anything more than that is wasted. But you do need a
certain temperament, and must be able to think for yourself. Then constantly look for opportunities. You can learn
every day. You can’t act every day, but you can learn every day. It’s like any game, if you enjoy playing it, you’ll do
well. But start early, and follow a framework that’s been successful.

Everybody has got a different circle of competence. The important thing is not how big the circle is, the important
thing is the size of the circle; the important thing is staying inside the circle

It is very hard to earn a lot as an investor when the business you are in doesn't earn very much money

You can learn something perhaps from the mistakes, but the big thing to do is to stick with the businesses you
understand. So if there is a generic mistake outside your circle of competence like buying something that somebody
tips you on or something of the sort. In an area you know nothing about, you should learn something from that which
is to stay with what you can figure out yourself. You really want your decision making to be by looking in the mirror.
Saying to yourself, “I am buying 100 shares of General Motors at $55 because……..” It is your responsibility if you
are buying it. There’s gotta be a reason and if you can’t state the reason, you shouldn’t buy it. If it is because someone
told you about it at a cocktail party, not good enough. It can’t be because of the volume or a reason like the chart
looks good.

When I look at our managers, I’m not trying to look at the guy who wakes up at night and says "E = MC 2" or
something. I am looking for people that function very, very well. And that means not having any weak links. The two
biggest weak links in my experience: I’ve seen more people fail because of liquor and leverage – leverage being
borrowed money. Donald Trump failed because of leverage. He simply got infatuated with how much money he could
borrow, and he did not give enough thought to how much money he could pay back.

You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without
borrowing. I’ve never borrowed a significant amount of money in my life. Never. Never will. I’ve got no interest in it.
The other reason is I never thought I would be way happier when I had 2X instead of X. You ought to have a good
time all the time as you go along. If you say "I’m taking this job – I don’t really like this job but in three years it will
lead to this," forget it. Find one you like right now.

I read all kinds of business publications. I read a lot of industry publications. I’ll grab whatever comes in the morning.
American Banker comes every day, so I’ll read that. I’ll read the Wall Street Journal. Obviously. I’ll read Editor and
Publisher, I’ll read Broadcasting, I’ll read Property Casualty Review, I’ll read Jeffrey Meyer’s Beverage Digest. I’ll
read everything. And I own 100 shares of almost every stock I can think of just so I know I’ll get all the reports. And I
carry around prospectuses and proxy material. Don’t read broker’s reports. You should be very careful with those.

"It takes 20 years to build a reputation and 5 minutes to ruin it. If you think about that,you'll do things differently."

Stop trying to predict the direction of the stock market, the economy, interest rates, or elections, and stop wasting
money on individuals that do this for a living
The basic ideas of investing are to look at stocks as businesses, use market fluctuations to your advantage, and seek a
margin of safety. That’s what Ben Graham taught us. A hundred years from now they will still be the cornerstones of
investing

Plenty of people have higher IQs, and plenty of people work more hours, but I am rational about things. But you have
to be able to control yourself; you can’t let your emotions get in the way of your mind.--Warren Buffet

The professors who taught Efficient Market Theory said that someone throwing darts at the stock tables could select
stock portfolio having prospects just as good as one selected by the brightest, most hard-working securities analyst.

Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always
efficient

Here's how Buffet elaborates on the subject of Avoiding Bad Businesses:

In the textile industry, we always had new machinery that held the promise of increasing our profit, but it never did
because everyone else bought the same machinery. It was sort of like being in a crowd, and everyone stands on tip-
toes – your view doesn’t improve, but your legs hurt
After years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve
difficult business problems. What we have learned is how to avoid them-- Warren Buffett

We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business
whose long-term future is predictable, because of short-term worries about an economy or a stock market that we
know to be unpredictable. Why scrap an informed decision because of an uninformed guess?--Warren Buffet (in his
letter to B-H shareholders

MBAs and Business schools

The activities of most professions are safe and necessary. If your wife is going to have a baby, it’s better to call the
obstetrician rather than try to deliver it yourself. Most professions add value. But the investment profession does not
do that, in aggregate. It makes $140 billion per year, and it basically does the same thing that one person could do if
he spent ten minutes per year thinking about his investments. I can’t think of another business like that. Plus, the
business is unique in that, the more you charge, the more money you bring in.

One of the great businesses is business schools. The more you charge, the better your reputation. The vast majority of
professional investors can’t add value. In aggregate, you can’t pay people 2 and 20 in an economy that produces 7%
annual growth and have investors be net better off. People will say that they’re the exception, though. Name 10
partnerships, and I’ll bet you that those partnerships won’t beat the S&P over the following ten years.

Then again, I’ve identified good managers before the fact. In 1969, when I closed my partnership, I recommended my
investors go with Bill Ruane and Sandy Gottesman. The ones who did did very well.

But it’s very hard for institutions such as pension funds to select superior investors. They end up going with the best
salesman, not the best investor.

CM: It should be a crime to entertain a state pension official. Watching these managers go after the business is not a
pretty sight.
If you are interested in business, or likely to be in business, an MBA is very useful. But, what is really important is
what you bring to a class in terms of being interested in the subject. If you view a course like accounting as a drudge
and a requirement, you are missing the whole game. Any course can be exciting. Mastering accounting is like
mastering a new language, it can be so much fun. The attitude should be one of discovery, that you are coming there
and discovering. Accounting is the Rosetta Stone of business.

Economics is fascinating, the first page of economics describes how mankind deals with insatiable wants and creates
the systems to fulfill these wants. It’s great stuff. Really how the world works. Business is a subsection, a fairly
understandable subsection, not like black holes, which are fairly hard to visualize, but business is every day stuff and
you are learning how the world works. You are 18-19 years old and learning about the world, understanding how this
great world works. The GDP per capita in the 20th century increased 6 to 1. Think of that, six times. Why does that
work here in the U.S., why doesn’t it work other places? The U.S. is a small part of the universe, but a very important
part and understanding that and seeing everything else against that backdrop for the rest of your life is fabulous.

You really need to be in something where cost is not the controlling factor. Hershey bars—you know, you go into a
drug store and say, “I want a Hershey bar,” and the guy says, “I’ve got this private label I make myself, same size as a
Hershey bar and it’s a nickel cheaper.” You walk across the street and buy a Hershey bar some place else. That’s
when you have a business. It’s when you walk across the street if the guy tries to sell you something, even if it is a
little cheaper.

But if you sell wheat, my son lost a farm and it’s a terrible business, and I told him the day someone walks into a
place like this and says, “I’d like some of [name-brand] corn, please,” you know you are in a good business. But when
they just say “Bring me some corn,” it’s a lousy business. In fact, such a lousy business, they had a fella that I read
about that he won the lottery and he was a farmer here in Nebraska that won 20 million dollars and the TV crew went
out to him and asked him, “What are you going to do with the 20 million dollars?” He says, “I think I’ll just keep
farming ‘til it’s all gone.” That’s what happens when you are in the commodity business. You don’t want to go near it.
A great IQ is not needed. There's relatively little correlation between a high IQ and investment success."

"Is the critical ability to detach yourself from the crowd something you're born with?"

"I've seen nothing to improve on Graham and Fisher. Just think about stocks as a business and then evaluate that
business. This requires insulating yourself from popular opinion."
RISK

Warren Buffet: We regard using [a stock's] volatility as a measure of risk is nuts. Risk to us is 1) the risk of
permanent loss of capital, or 2) the risk of inadequate return. Some great businesses have very volatile returns --
for example, See's usually loses money in two quarters of each year -- and some terrible businesses can have
steady results.

Charlie Munger: "How can professors spread this? I've been waiting for this craziness to end for decades. It's
been dented, but it's still out there."

WB: "If someone starts talking to you about beta, zip up your pocketbook
 BERKSHIRE HATHAWAY INC.
ACQUISITION CRITERIA
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround”
situations),
(3) Businesses earning good returns on equity while employing little or no debt,
(4) Management in place (we can’t supply it),
(5) Simple businesses (if there’s lots of technology, we won’t understand it),
(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily,
about a transaction when price is unknown).
The larger the company, the greater will be our interest: We would like to make an acquisition in the $5-20 billion
range. We are not interested, however, in receiving suggestions about purchases we might make in the general stock
market.
We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer —
customarily within five minutes — as to whether we’re interested. We prefer to buy for cash, but will consider issuing
stock when we receive as much in intrinsic business value as we give. We don’t participate in auctions.

Business Analysis
The Ideal Business"

Buffett: The ideal business is one that generates very high returns on capital and can invest that capital back into the
business at equally high rates. Imagine a $100 million business that earns 20% in one year, reinvests the $20 million
profit and in the next year earns 20% of $120 million and so forth. But there are very very few businesses like this.
Coke has high returns on capital, but incremental capital doesn't earn anything like its current returns. We love
businesses that can earn high rates on even more capital than it earns. Most of our businesses generate lots of money,
but can't generate high returns on incremental capital -- for example, See's and Buffalo News. We look for them [areas
to wisely reinvest capital], but they don't exist.

So, what we do is take money and move it around into other businesses. The newspaper business earned great returns
but not on incremental capital. But the people in the industry only knew how to reinvest it [so they squandered a lot of
capital]. But our structure allows us to take excess capital and invest it elsewhere, wherever it makes the most sense.
It's an enormous advantage.

See's has produced $1 billion pre-tax for us over time. If we'd deployed that in the candy business, the returns would
have been terrible, but instead [we took the money out of the business and redeployed it elsewhere. Look at the
results!]

Munger: There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The
second earns 12%, but all the excess cash must be reinvested -- there's never any cash. It reminds me of the guy who
looks at all of his equipment and says, "There's all of my profit." We hate that kind of business.

Buffett: We like to be able to move cash around and find it's best use. We'd love to have our companies redeploy cash,
but they can't. Gillette has a great business, but can't sensibly reinvest all of the profit.

We don't think the batting average of American industry redeploying capital has been very great. We knock other
people doing what has made us so successful.
Munger: I'm uncomfortable with that, which is why we say negative things [to discourage others from trying to do
what we do].

Time is the friend of the wonderful business; it is the enemy of the lousy business. If you are in a lousy business for a
long time, you will get a lousy result even if you buy it cheap. If you are in a wonderful business for a long time, even
if you pay a little bit too much going in you will get a wonderful result if you stay in a long time.

have to really understand the economics of a business and the kind of people you are getting into business with. They
have to love their business. They have to feel that they have been creative, that it is their painting, I am not going to
disturb it, just give them more canvas and more brushes, but its their painting, from our standpoint any way. The
whole place will reflect the attitude of the person at the top, if you have someone at the top who doesn’t care, the
people down below won’t care. On the other hand, if you have someone at the top who cares a great deal, that will be
evident across the organization.

I don’t think about the macro stuff. What you really want to in investments is figure out what is important and
knowable. If it is unimportant and unknowable, you forget about it. What you talk about is important but, in my view,
it is not knowable.
But we have never not bought or bought a business because of any Macro feeling of any kind because it doesn’t make
any difference. We don’t want to pass up the chance to do something intelligent because of some prediction about
something we are no good on anyway. So we don’t read or listen to in relation to macro factors at all. The typical
investment counselor organization goes out and they bring out their economist and they trot him out and he gives you
this big macro picture. And they start working from there on down. In our view that is nonsense.

There are basically two ways to look at change. We see change as the enemy of investments, if it wasn’t the richest
people would be librarians. Some businesses will change very quickly. We are looking for ones that don’t. If you can
predict the change then you can become very rich, but the net investment (e.g. from what went on at Kitty Hawk – air
flight) to equity investors is a huge negative. For example, I have a list of over 2000 companies that made
automobiles, now the last two, GM and Ford, are in trouble. Hundreds are out of business – many people didn’t know
that Maytag and Du Pont made automobiles. The net investment for investors has not been a great deal.

We look for certainty of what won’t change. You mentioned Gillette. After 100 years, Gillette still has 70% market
share, and yet the distribution, product and raw materials are not mysterious. It has survived within our capitalist
system and you know its products will be used regularly

We own a lot of Gillette and you can sleep pretty well at night if you think of a couple billion men with their hair
growing on their faces. It is growing all night while you sleep -Warren Buffet

Coke sells 50% of the carbonated beverages worldwide: about 1.3 billion 8 ounce servings, higher than last year and
the year before. I guarantee Coke, Wrigleys and Gillette will dominate. The internet won’t change what brands people
like.

We are looking for the absence of change. Fruit of the Loom and Haynes together have 80% of boys underwear in the
US. I guess we will keep wearing underwear. Bill Gates welcomes the absence of change, he just doesn’t get it in his
business. Microsoft and E-Bay have some moat. If you can identify change, that is great, but it is a lot riskier and so is
the chance of our strategy not working. So we look for absence of change. We don’t like to lose money. Capitalism is
pretty brutal. We look for mundane products that everyone needs. Patents are the worst way to ensure demand. There
is still plenty of opportunity to find predictable demand. The problem isn’t the lack of opportunities, it’s the prices.
The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a
different price – that makes a great business.

We look for certainty of what won’t change. You mentioned Gillette. After 100 years, Gillette still has 70% market
share, and yet the distribution, product and raw materials are not mysterious. It has survived within our capitalist
system and you know its products will be used regularly.

Coke sells 50% of the carbonated beverages worldwide: about 1.3 billion 8 ounce servings, higher than last year and
the year before. I guarantee Coke, Wrigleys and Gillette will dominate. The internet won’t change what brands people
like.

But if you don’t know enough to know about the business instantly, you won’t know enough in a month or in two
months. You have to have sort of the background of understanding and knowing what you do or don’t understand.
That is the key. It is defining your circle of competence

Our investments continue to be few in number and simple in concept: The truly big investment idea can usually be
explained in a short paragraph. We like a business with enduring competitive advantages that is run by able and
owner-oriented people. When these attributes exist, and when we can make purchases at sensible prices, it is hard to
go wrong.

Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty
doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both
easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative
characterized by many constantly shifting and complex variables.

Moat – Competitive ability of a business to create entry barriers!

Well one thing that isn't a source of a moat is technology because that can be duplicated and always will be,
eventually, if that's the only advantage you have. Your best hope in a situation like this is to be acquired or
go public and sell all your shares before investors realize you don't have a sustainable advantage.
Technology is one type of advantage that's short-lived. There are others, such as a good management team
or a catchy advertising campaign or a hot fashion trend. These things produce temporary advantages but
they change over time, or can be duplicated by competitors.

An economic moat is a structural thing. It's like Southwest Airlines in the 1990s – it was so deeply
ingrained in the company culture, in every employee, that no one could copy it, even though everyone kind
of knew how Southwest was doing it. If your competitors know your secret and yet still can't copy it, that's a
structural advantage. That's a moat.

There are only four sources of economic moats that are hard to duplicate, and thus, long-lasting.

One source would be economies of scale and scope. Wal-Mart is an example of this, as is Cintas in the
uniform rental business or Procter & Gamble or Home Depot and Lowe's.

Another source is the network affect, ala eBay or Mastercard or Visa or American Express.
A third would be intellectual property rights, such as patents, trademarks, regulatory approvals, or
customer goodwill. Disney, Nike, or Genentech would be good examples here.

A fourth and final type of moat would be high customer switching costs. Paychex and Microsoft are
great examples of companies that benefit from high customer switching costs.

These are the only four types of competitive advantages that are durable, because they are very difficult for
competitors to duplicate. And just like a company needs to develop a moat or suffer from mediocrity, an
investor needs some sort of edge over the competition or he'll suffer from mediocrity