Rising Sum
Wednesday, 18 October 2012
Presenter Brian Kelly
Value Investing introduction
Warren Buffett & Berkshire Hathaway
Berkshire Hathaway acquisition criteria
Key Ratios & Alpha Slopes
The Rising Sum model
Suggested analysis method & Value reports
– Screening
– Company Profiles – Apple & IBM
– Watchlist
Value Investing
Value investing is an investment paradigm that derives
from the ideas on investment and speculation that
Benjamin Graham and David Dodd in 1928.
It generally involves buying securities whose shares
appear underpriced.
High-profile proponents of value investing, including
Berkshire Hathaway chairman Warren Buffett, have argued
that the essence of value investing is buying stocks at less
than their Intrinsic Value.
The discount of the market price to the intrinsic value is
what Benjamin Graham called the "margin of safety". The
Intrinsic Value is the discounted value of future cash flows.
Mr. Market. An allegory used to describe the fluctuations
in the market and describes a man who will turns up at
your door, every day, and give you a price for your stocks.
He is best ignored.
Value Investing – Warren Buffett
Born September 30th 1930, he now has an estimated worth of $44 billion
Warren Buffet studied under Benjamin Graham at Columbia Business School before working
for him as a security analyst at Graham-Newman Corp
Via a partnership he bought a textiles manufacturing company called Berkshire Hathaway,
and turned it into an investment conduit due to the favorable tax benefits when companies
own other companies
In 1970, as chairman of Berkshire Hathaway, Buffett began writing his now-famous annual
letters to shareholders
Compounded annual gain from 1965 to 2011 is 19.8% (equivalent S&P500 return is 9.2%).
Warren Buffett investment record*
*source: Berkshire Hathaway 2011 Annual Report
The Berkshire Hathaway acquisition criteria
Large purchases (at least $75 million of pre-tax earnings unless the business will fit
into one of our existing units)
Demonstrate consistent earning power (future projections are of no interest to
us, nor are “turnaround” situations)
Businesses earning good returns on equity, while employing little or no debt,
Management in place (we can’t supply it)
Simple businesses (if there’s lots of technology, we won’t understand it)
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)
Return On Equity
Sustained Return on equity implies sustained growth but it’s important to check
that this is the case.
Shareholders’ equity can be calculated by subtracting the current liabilities from
the current assets (aka net assets). Retained earnings, in most cases, make up the
largest portion of shareholders equity.
A company improving its return on equity will have a positive AlphaSlope.
Net Profit Margin – ‘earnings power’
Net profit margin (aka return on sales) tells you how much profit a company
generates for each unit of sales
Companies that increase their costs quicker than their revenue will see their net
profit margin decrease
A company improving its net profit margin will have a positive AlphaSlope.
Intrinsic Value & Margin of Safety - IBM
Intrinsic Value is the sum of all future cash flows, discounted back to today. It
uses the Compound Annual Growth Rate (CAGR) for the timeframe in
question to derive a Sustainable Growth rate.
Margin of Safety is the difference between intrinsic value and the current
market price.
A key question to ask – Is the Margin of Safety sufficient when considering the
required sustainable growth?
Alpha Slopes–a simple method for screening companies
by modeling ratios over time
Traditional screeners rank
companies by latest results and
would generate investments ideas
in the order B, C and A
Alphaslope screening ranks
the companies based on their
trend – i.e. Consistent
improvement. The tool would
generate investment ideas in
the order C, A and B –
although B would likely be
removed from the result set
as is it is on a downward
trend and less than zero
How diverse is the market?
The Bell Curve distribution for slopes shows how effectively Rising Sum can
provide identification / screening of companies in an index
Comparing the Return On Equity Alpha Slope with CAGR
Companies with
negative RoE slopes
have either positive
or negative CAGR
The majority of companies with
positive RoE slopes also had
positive growth
Very few companies that have
positive Return On Equity
slopes had negative CAGR
Note: additional ratio alphaslopes can be applied to further filter out negative CAGR companies
The Rising Sum model
Existing tools screen for
companies based upon
But, a Value Investor needs to
screen for
• Latest financial data e.g. P/E,
MarCap, etc.
• Consistent Earnings
• Return on Equity (TTM, averages,
recent year)
• Consistent Returns on Equity
• Book Value e.g. Price/book ratio
• Intrinsic Value & Margin of Safety
“Demonstrated consistent earning power” - over time
not just latest results.
“Businesses earning good returns on equity, while
employing little or no debt” – not just last period.
“An offering price” - which is lower than intrinsic value
by a sufficient margin of safety
"Book value is what the owners put into the business, intrinsic
value is what they take out of it.“
Warren Buffett
Suggested analysis method
Step 1
• Remove companies with
negative CAGR
• MoS between 75 and -10
Step 2
• Return on Equity AlphaSlope
• Net Profit Margin Alpha Slope
• Net Profit Margin > 9%
Step 3
• Value Scores
Step 4
• Annual Reports, news, quarterly
data, press releases
Step 5
• Top 5 selection
Companies are evaluated based on 10
different criteria:
•Margin of Safety
•Return on Equity AlphaSlope value
•ROE AlphaSlope consistency
•Net Profit Margin AlphaSlope value
•NPM AlphaSlope consistency
•NPM financial value
•How sustainable is their growth rate?
•Is there a moat to protect the business?
•How experienced is the management
•A final discretionary score is given based
on other key financial ratios
Company Profiles – Apple & IBM