This is part 3 of the book summary covering chapters 11 and 12. Part I can be found here. Part 2 can be found here
Chapter 11: When a bargain is NOT a bargain? This Chapter deals with companies to avoid.
Many companies are cheap for a reason. They have fundamental problems. We have to determine why a company's shares are cheap and which ones have little chance of recovery.
Why do stocks become cheap
1) Company has taken on too much debt. - Future is unknown. If you have too much debt, smaller chance of surviving an economic downturn. Graham’s simple method: Company should own twice as much as it owes. Avoid others.
2) Company falls short of analysts' earnings estimates. - May create a value opportunity. However, if trends continue price likely to fall.
3) Cyclical stocks (automobiles, large appliances, steel and construction) Avoid overly leveraged companies.
4) Labor contract issues. (Big Three Auto, Airlines) - Unfunded pensions that are large. Companies may not be able to pay. Avoid such companies.
5) Increased competition - If facing strong competition from a more efficient competitor with lower costs, then move on to the next candidate.
6) Obsolescence (Blockbuster) - Avoid companies that are subject to technological obsolescence.
7) Corporate or accounting fraud. - No way to uncover before it becomes public - stay away from companies whose financial reports are overly complicated. Best companies are those that can be easily understood. And if they have a moat, it is even better. Moat can be in the form of patents, brand name, or Size. (Walmart) Moats do not last forever, but allow a company to make profits for many years. Chris likes businesses he understands and for which there is ongoing need Examples: Banking, Food, and Beverage, Consumer staples like detergents, toothpaste, pens, and pencils. People tend to use the same products over and over again. Skepticism is needed when considering candidates.
Chapter 12: Balance sheet checkup
Start with the balance sheet. - Liquidity is good - Avoid too much debt. - Current ratio = current assets / current liabilities. Ability to pay short term obligations. Rule of thumb is 2. It could vary by business. Compare this to other companies in the industry. Also look at it over several years. Declining ratio may indicate liquidity problem. - Working capital. - Quick Ratio - Inventory level and growth with respect to sales over several years. - Check long term liabilities versus assets over years. - Computer shareholder equity or book value. Subtract intangibles (patents, trademarks) - Debt to Equity ratio - Take both ST and LT debt./ shareholder equity. Compare this number to other companies in the industry - The less debt means greater margin of safety. - Evaluate levels and also the trends across years. - If BV is a lot of intangible assets like goodwill or excess inventory in relation to sales, it may not be quite the bargain on a P/B basis. - Sometimes BV is understated. Land or stock investments may be carried at cost. This has been true over the years in foreign stocks in particular. Winning means not losing. Strong balance sheet shows ability to survive when the going gets tough.
Chapter 11: When a bargain is NOT a bargain? This Chapter deals with companies to avoid.
Many companies are cheap for a reason. They have fundamental problems. We have to determine why a company's shares are cheap and which ones have little chance of recovery.
Why do stocks become cheap
1) Company has taken on too much debt. - Future is unknown. If you have too much debt, smaller chance of surviving an economic downturn. Graham’s simple method: Company should own twice as much as it owes. Avoid others.
2) Company falls short of analysts' earnings estimates. - May create a value opportunity. However, if trends continue price likely to fall.
3) Cyclical stocks (automobiles, large appliances, steel and construction) Avoid overly leveraged companies.
4) Labor contract issues. (Big Three Auto, Airlines) - Unfunded pensions that are large. Companies may not be able to pay. Avoid such companies.
5) Increased competition - If facing strong competition from a more efficient competitor with lower costs, then move on to the next candidate.
6) Obsolescence (Blockbuster) - Avoid companies that are subject to technological obsolescence.
7) Corporate or accounting fraud. - No way to uncover before it becomes public - stay away from companies whose financial reports are overly complicated. Best companies are those that can be easily understood. And if they have a moat, it is even better. Moat can be in the form of patents, brand name, or Size. (Walmart) Moats do not last forever, but allow a company to make profits for many years. Chris likes businesses he understands and for which there is ongoing need Examples: Banking, Food, and Beverage, Consumer staples like detergents, toothpaste, pens, and pencils. People tend to use the same products over and over again. Skepticism is needed when considering candidates.
Chapter 12: Balance sheet checkup
Start with the balance sheet. - Liquidity is good - Avoid too much debt. - Current ratio = current assets / current liabilities. Ability to pay short term obligations. Rule of thumb is 2. It could vary by business. Compare this to other companies in the industry. Also look at it over several years. Declining ratio may indicate liquidity problem. - Working capital. - Quick Ratio - Inventory level and growth with respect to sales over several years. - Check long term liabilities versus assets over years. - Computer shareholder equity or book value. Subtract intangibles (patents, trademarks) - Debt to Equity ratio - Take both ST and LT debt./ shareholder equity. Compare this number to other companies in the industry - The less debt means greater margin of safety. - Evaluate levels and also the trends across years. - If BV is a lot of intangible assets like goodwill or excess inventory in relation to sales, it may not be quite the bargain on a P/B basis. - Sometimes BV is understated. Land or stock investments may be carried at cost. This has been true over the years in foreign stocks in particular. Winning means not losing. Strong balance sheet shows ability to survive when the going gets tough.
