The Five Rules for Successful Stock Investing

The Five Rules for Successful Stock Investing consists of two parts: The first part is about the analysis of stocks, whereas the second part provides an overview of different business sectors from an investor's point of view.

I found this book a very informative read, and especially the explanations on reading financial statements were helpful for me as a beginner. The book is easy to follow though the writing style is a bit boring. And as the book was written almost ten years ago, a few things feel dated.

My notes

Foreword

Funds are great for those who don't want to spend a lot of time doing research. But if you enjoy analyzing companies [...] you can do perfectly well investing in equities yourself.

Buffett [...] inspired me by showing how much fun and intellectually challenging investing could be.

A common quality of successful investors is the steadfast ability to think independently. Don't be swayed by what the "experts" say – even us. Graham and Buffett often point out that if your reasoning is right, that's all you need to worry about.

Introduction: Picking Great Stocks Is Tough

Successful investing is simple, but it's not easy.

Picking individual stocks requires hard work, discipline, and an investment of time (as well as money). Expecting to make a large amount of money with only a little effort is like expecting to shoot a great round of golf the first time you pick up a set of clubs. There's no magic formula, and there's no guarantee of success.

The basic investment process is simple: Analyze the company and value the stock. If you avoid the mistake of confusing a great company with a great investment – and the two can be very different – you'll already be ahead of many of your investing peers.

Your goal as an investor should be to find wonderful businesses and purchase them at reasonable prices. Great companies create wealth, and as the value of the business grows, so should the stock price in time. In the short term, the market can be a capricious thing – wonderful businesses can sell at fire-sale prices, while money-losing ventures can be valued as if they had the rosiest of futures – but over the long haul, stock prices tend to track the value of the business.

You have to [...] understand the businesses of the stocks you own if you hope to be a successful long-term investor. When firms do well, so do their shares, and when business suffers, the stock will as well.

Company fundamentals have a direct effect on share prices. This principle applies only over a long time period – in the short term, stock prices can (and do) move around for a whole host of reasons that have nothing whatsoever to do with the underlying value of the company. We firmly advocate focusing on the long-term performance of businesses because the short-term price movement of a stock is completely unpredictable.

Successful stock-picking means having the courage to take a stance that's different from the crowd. There will always be conflicting opinions about the merits of any company, and it's often the companies with the most conflict surrounding them that make the best investments. Thus, as an investor, you have to be able to develop your own opinion about the value of a stock, and you should change that value only if the facts warrant doing so – not because you read a negative news article or because some pundit mouths off on TV. Investment success depends on personal discipline, not on whether the crowd agrees or disagrees with you.

The Five Rules for Successful Stock Investing

Here are the five rules that we recommend:

1. Do your homework.
2. Find economic moats.
3. Have a margin of safety.
4. Hold for the long haul.
5. Know when to sell.

[...] perhaps the most common mistake that investors make is failing to thoroughly investigate the stocks they purchase. Unless you know the business inside and out, you shouldn't buy the stock. This means that you need to develop an understanding of accounting so that you can decide for yourself what kind of financial shape a company is in.

What separates a bad company from a good one? Or a good company from a great one? In large part, it's the size of the economic moat a company builds around itself. The term economic moat is used to describe a firm's competitive advantage.

The key to identifying wide economic moats can be found in the answer to a deceptively simple question: How does a company manage to keep competitors at bay and earn consistently fat profits? If you can answer this, you've found the source of the firm's economic moat.

Finding great companies is only half of the investment process – the other half is assessing what the company is worth. You can't just go out and pay whatever the market is asking for the stock because the market might be demanding too high a price. And if the price you pay is too high, your investment returns will likely be disappointing.

Always include a margin of safety into the price you're willing to pay for a stock. If you later realize you overestimated the company's prospects, you'll have a built-in cushion that will mitigate your investment losses. The size of your margin of safety should be larger for shakier firms with uncertain futures and smaller for solid firms with reasonably predictable earnings.

[...] not making money is a lot less painful than losing money you already have.

[...] if you don't use discipline and conservatism in figuring out the prices you're willing to pay for stocks, you'll regret it eventually. Valuation is a crucial part of the investment process.

Investing should be a long-term commitment because short-term trading means that you're playing a loser's game. The costs really begin to add up – both the taxes and the brokerage costs – and create an almost insurmountable hurdle to good performance.

Knowing when it's appropriate to bail out of a stock is at least as important as knowing when to buy one, yet we often sell our winners too early and hang on to our losers for too long.

Even the greatest companies should be sold when their shares sell at egregious values.

As an investor, you should always be seeking to allocate your money to the assets that are likely to generate the highest return relative to their risk. There's no shame in selling a somewhat undervalued investment – even one on which you've lost money – to free up funds to buy a stock with better prospects.

Don't sell just because the price has gone up or down, but give it some serious thought if one of the following things has happened: You made a mistake buying it in the first place, the fundamentals have deteriorated, the stock has risen well above its intrinsic value, you can find better opportunities, or it takes up too much space in your portfolio.

Seven Mistakes to Avoid

Unless you know how to avoid the most common mistakes of investing, your portfolio's returns won't be anything to get excited about. You'll find that it takes many great stock picks to make up for just a few big errors.

Loading up your portfolio with risky, all-or-nothing stocks – in other words, swinging for the fences on every pitch – is a sure route to investment disaster. For one thing, the insidious math of investing means that making up large losses is a very difficult proposition – a stock that drops 50 percent needs to double just to break even. For another, finding the next Microsoft when it's still a tiny start-up is really, really difficult. You're much more likely to wind up with a company that fizzles than a truly world-changing company, because it's extremely difficult to discern which is which when the firm is just starting out.

You have to be a student of the market's history to understand its future. Any time you hear someone say, "It really is different this time", turn off the TV and go for a walk.

It seems entirely logical, but the reality is that great products do not necessarily translate into great profits.

It's very tempting to look for validation – or other people doing the same thing – when you're investing, but history has shown repeatedly that assets are cheap when everyone else is avoiding them.

You'll do better as an investor if you think for yourself and seek out bargains in parts of the market that everyone else has forsaken, rather than buying the flavor of the month in the financial press.

Market timing is one of the all-time great myths of investing. There is no strategy that consistently tells you when to be in the market and when to be out of it, and anyone who says otherwise usually has a market-timing service to sell you.

The only reason you should ever buy a stock is that you think the business is worth more than it's selling for – not because you think a greater fool will pay more for the shares a few months down the road.

Cash flow is the true measure of a company's financial performance, not reported earnings per share.

Economic Moats

Investors often judge companies by looking at which ones have increased profits the most and assuming the trend will persist in the future. But more often than not, the firms that look great in the rearview mirror wind up performing poorly in the future, simply because success attracts competition as surely as night follows day. And the bigger the profits, the stronger the competition. That's the basic nature of any (reasonably) free market – capital always seeks the areas of highest expected return. Therefore, most highly profitable firms tend to become less profitable over time as competitors chip away at their franchises.

To analyze a company's economic moat, follow these four steps:

• Evaluate the firm's historical profitability. Has the firm been able to generate a solid return on its assets and on shareholders' equity? This is the true litmus test of whether a firm has built an economic moat around itself.
• If the firm has solid returns on capital and consistent profitability, assess the sources of the firm's profits. Why is the company able to keep competitors at bay? What keeps competitors from stealing its profits?
• Estimate how long a firm will be able to hold off competitors, which is the company's competitive advantage period. Some firms can fend off competitors for just a few years, and some firms may be able to do it for decades.
• Analyze the industry's competitive structure. How do firms in this industry compete with one another? Is it an attractive industry with many profitable firms or a hypercompetitive one in which participants struggle just to stay afloat?

Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

If a firm's free cash flow as a percentage of sales is around 5 percent or better, you've found a cash machine [...]. Strong free cash flow is an excellent sign that a firm has an economic moat.

Net margin is simply net income as a percentage of sales, and it tells you how much profit the firm generates per dollar of sales. In general, firms that can post net margins above 15 percent are doing something right.

Return on equity (ROE) is net income as a percentage of shareholders' equity, and it measures profits per dollar of the capital shareholders have invested in a company. [...] As a rule of thumb, firms that are able to consistently post ROEs above 15 percent are generating solid returns on shareholders' money, which means they're likely to have economic moats.

Return on assets (ROA) is net income as a percentage of a firm's assets, and it measures how efficient a firm is translating its assets into profits. Use 6 percent to 7 percent as a rough benchmark – if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers.

Consistency is important when evaluating companies, because it's the ability to keep competitors at bay for an extended period of time – not just for a year or two – that really makes a firm valuable. Five years is the absolute minimum time period for evaluation, and I'd strongly encourage you to go back 10 years if you can.

When you're examining the sources of a firm's economic moat, the key thing is to never stop asking, "Why?" Why aren't competitors stealing the firm's customers? Why can't a competitor charge a lower price for a similar product or service? Why do customers accept annual price increases? When possible, look at the situation from the customer's perspective. What values does the product or service bring to the customer? How does it help them run their own business better? Why do they use one firm's product or service instead of a competitor's?

In general, there are five ways that an individual firm can build sustainable competitive advantage:

1. Creating real product differentiation through superior technology or features
2. Creating perceived product differentiation through a trusted brand or reputation
3. Driving costs down and offering a similar product or service at a lower price
4. Locking in customers by creating high switching costs
5. Locking out competitors by creating high barriers to entry or high barriers to success

[...] although firms can occasionally generate enormous excess profits – and enormous stock returns – by staying one step ahead of the technological curve, these profits are usually short-lived. Unless you are familiar enough with the inner workings of an industry to know when a firm's products are being supplanted by better ones, be wary of firms that rely solely on innovation to sustain their competitive advantage.

[...] a strong brand can constitute a very wide economic moat. The wonderful thing about a brand is that as long as customers perceive your product or service as better than everyone else's, it makes relatively little difference whether it actually is different.

In general, firms can create cost advantages by either inventing a better process or achieving a larger scale.

If you can make it difficult – in terms of either money or time – for a customer to switch to a competing product, you can charge your customers more and make more money – simple in theory, but difficult in practice.

When you're looking for evidence of high customer switching costs, these questions should help:

• Does the firm's product require a significant amount of client training? If so, customers will be reluctant to switch and incur lost productivity during the training period.
• Is the firm's product or service tightly integrated into customers' businesses? Firms don't change vendors of mission-critical products often because the costs of a botched switch may far outweigh the benefits of using the new product or service.
• Is the firm's product or service an industry standard? Customers may feel pressure from their own clients – or their peers – to continue using a well-known and well-respected product or service.
• Is the benefit to be gained from switching small relative to the cost of switching?
• Does the firm tend to sign long-term contracts with clients? This is often a sign that the client does not want to frequently switch vendors.

Although patents and licenses can do a great job of keeping competitors at bay and maintaining high profit margins, they can also be ephemeral. If you're investigating a firm whose economic moat depends solely on a single patent or other regulatory approval, don't forget to investigate the likelihood of that approval disappearing unexpectedly.

Think about an economic moat in two dimensions. There's depth – how much money the firm can make – and there's width – how long the firm can sustain above-average profits.

Although the attractiveness of an industry doesn't tell the whole story, it's important to get a feel for the competitive landscape. Some industries are just easier to make money in than others.

The Language of Investing

As an investor, you're mainly going to be interested in the balance sheet, the income statement, and the statement of cash flows. These three tables are your windows into corporate performance, and they're the place to start when you're analyzing a company.

The balance sheet is like a company's credit report because it tells you how much the company owns (assets) relative to what it owes (liabilities) at a specific point in time. [...] The income statement, meanwhile, tells how much the company made or lost in accounting profits during a year or a quarter. Unlike the balance sheet [...] the income statement records revenues and expenses over a set period, such as a fiscal year. Finally, there's the statement of cash flows, which records all the cash that comes into a company and all of the cash that goes out. The statement of cash flows ties the income statement and balance sheet together.

Accrual accounting is a key concept for understanding financial statements. The income statement matches sales with the corresponding expenses when a service or a good is provided to the buyer, but the cash flow statement is concerned only with when cash is received and when it goes out the door.

Financial Statements Explained

[...] reading financial statements is the foundation for analyzing companies.

The balance sheet [...] tells you how much a company owns (its assets), how much it owes (its liabilities), and the difference between the two (its equity). Equity represents the value of the money that shareholders have invested in the firm [...].

"Cash and equivalents" usually contains money market funds or anything that can be liquidated quickly and with minimal price risk, whereas "short-term investments" is similar to cash – usually, bonds that have less than a year to maturity and earn a higher rate of return than cash but would take a bit of effort to sell.

[...] accounts receivable are bills that the company hasn't yet collected but for which it expects to receive payment soon.

Comparing the growth rate of accounts receivable with the growth rate of sales is a good way to judge whether a company is doing a good job collecting the money that it's owed by customers.

You'll often see an "allowance for doubtful accounts" just after accounts receivable on the balance sheet. This is the company's estimate of how much money it's owed by deadbeat customers, and which it's consequently unlikely to collect.

There are several types of inventories, including raw materials that have not yet been made into a finished product, partially finished products, and finished products that have not yet been sold. Inventories are especially important to watch in manufacturing and retail firms, and their value on the balance sheet should be taken with a grain of salt. Because of the way inventories are accounted for, their liquidation value may very well be a far cry from their value on the balance sheet.

Inventories soak up capital – cash that's been converted into inventory sitting in a warehouse can't be used for anything else. The speed at which a company turns over its inventory can have a huge impact on profitability because the less time cash is tied up in inventory, the more time it's available for use elsewhere. You can calculate a metric called inventory turnover by dividing a company's cost of goods sold by its inventory level.

Noncurrent assets are assets that are not expected to be converted into cash or used up within the reporting period. The big parts of this section are property, plant, and equipment (PP&E); investments; and intangible assets.

The most common form of intangible assets is goodwill, which arises when one company acquires another. Goodwill is the difference between the price the acquiring company pays and tangible value – or equity – of the target company.

[...] the value of goodwill that shows up on the balance sheet is very often far more than the asset is actually worth.

Accounts payable: These are bills the company owes to somebody else and are due to be paid within a year.

Noncurrent liabilities are the flip side of noncurrent assets. They represent money the company owes one year or more in the future.

Retained earnings is a cumulative account; therefore, each year that the company makes a profit and doesn't pay it all out as dividends, retained earnings increase. Likewise, if a company has lost money over time, retained earnings can turn negative and is often renamed "accumulated deficit" on the balance sheet. Think of this account as a company's long-term track record at generating profits.

Be sure to check the "revenue recognition policies" buried in the financial statements so you know what you're looking at – companies can record revenue at different times depending on the business that they're in.

Cost of sales, also known as cost of goods sold, represents the expenses most directly involved in creating revenue, such as labor costs, raw materials (for manufacturers), or the wholesale price of goods (for retailers).

Gross profit is simply revenue minus cost of sales. Once you have gross profit, you can calculate a gross margin, which is gross profit as a percentage of revenue. Essentially, this tells you how much a company is able to mark up its goods.

[...] the more differentiated a company's products are, the more it can mark up its good over what it costs to manufacture them.

Selling, General, and Administrative Expenses (SG&A), also known as operating expenses, includes items such as marketing, administrative salaries, and, sometimes, research and development. (Research and development is usually broken out as a separate line item, as is marketing for firms that spend large amounts on advertising.) You'll often see a relationship between SG&A and gross margin – firms that are able to charge more for their goods have to spend more on salespeople and marketing. You can get a feel for how efficient a firm is by looking at SG&A as a percentage of revenues – a lower percentage of operating expenses relative to sales generally means a tighter, more cost-effective firm.

Depreciation and Amortization: When a company buys an asset intended to last a long time, such as a new building or a piece of machinery, it charges off a portion of the cost of that asset on its income statement over a series of years. This number is occasionally broken out separately on the income statement, but it's usually rolled into operating expenses. It's always included in the cash flow statement, though, so you can look there to see how much a company's net income was affected by noncash charges such as depreciation.

Nonrecurring Charges/Gains is the catch-all area where companies put all the one-time charges or gains that aren't part of their regular, ongoing operations, such as the cost of closing a factory or the gain from selling a division. Ideally, you'd want to see this area of the income statement blank most of the time.

Operating Income is equal to revenues minus cost of sales and all operating expenses. Theoretically, it represents the profit the company made from its actual operations, as opposed to interest income, one-time gains, and so forth. In practice, companies often include nonrecurring expenses (such as write-offs) in figuring operating income, and you have to add back one-time charges (or subtract one-time gains) yourself.

Interest Income/Expense represents interest the company has paid on bonds it has issued or received on bonds or cash that it owns.

Net Income represents (at least theoretically) the company's profit after all expenses have been paid. [...] Although net income is the number you'll most often see companies tout in their press releases, don't forget that it can be wildly distorted by one-time charges and/or investment income.

Number of Shares (Basic and Diluted) represents the number of shares used in calculating earnings per share; it represents the average number of shares outstanding during the reporting period. Basic shares include only actual shares of stock, and you should pretty much ignore it – the fact that it's still recorded in financial statements is more of a historical legacy than anything else. Diluted shares, however, include securities that could potentially be converted into shares of stock, such as stock options and convertible bonds. Given the amount of egregious granting of stock options that has occurred over the past several years, it's the diluted number that you'll want to look at, because you want to know the degree to which your stake in the firm could potentially be shrunk (or diluted) if all those option-holders convert their options into shares.

The cash flow statement strips away all the abstract, noncash items such as depreciation that you see on the income statement and tells you how much actual cash the company has generated. [...] The cash flow statement is divided into three parts: cash flows from operating activities, from investing activities, and from financing activities.

If you can't understand how a dollar flows from a company's customers back through to shareholders, something's amiss. Either the company's business model is too confusing or you need to do more digging before committing any of your money.

When you're evaluating a company's liabilities, remember that debt is a fixed cost. A big chunk of long-term debt can be risky for a company because the interest has to be paid no matter how business is doing.

Analyzing a Company – The Basics

Because [analyzing companies] can be a daunting task, I suggest that you break down the process into five areas:

1. Growth: How fast has the company grown, what are the sources of its growth, and how sustainable is that growth likely to be?
2. Profitability: What kind of returns does the company generate on the capital it invests?
3. Financial health: How solid is the firm's financial footing?
4. Risks/bear case: What are the risks to your investment case? There are excellent reasons not to invest in even the best-looking firms. Make sure you look at the full story and investigate the negatives as well as the positives.
5. Management: Who's running the show? Are they running the company for the benefits of shareholders or themselves?

You can't just look at a series of past growth rates and assume that they'll predict the future [...]. It's critical to investigate the sources of a company's growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that's generated by cost-cutting or accounting tricks.

In the long run, sales growth drives earnings growth. Although profit growth can outpace sales growth for a while if a company is able to do an excellent job cutting costs or fiddling with the financial statements, this kind of situation simply isn't sustainable over the long haul – there's a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottom line. In general, sales growth stems from one of four areas:

1. Selling more goods or services
2. Raising prices
3. Selling new goods or services
4. Buying another company

If you don't know how fast the company would have grown without acquisitions, don't buy the shares – because you never know when the acquisitions will stop. Remember, the goal of a successful investor is to buy great businesses, not successful merger and acquisition machines.

The first component of ROA (Return on Assets) is simply net margin, or net income divided by sales, and it tells us how much of each dollar of sales a company keeps as earnings after paying all the costs of doing business. The second component is asset turnover, or sales divided by assets, which tells us roughly how efficient a firm is at generating revenue from each dollar of assets. Multiply these two together, and you have return on assets, which is simply the amount of profits that a company is able to generate per dollar of assets. Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating assets into profits.

ROA helps us understand that there are two routes to excellent operational profitability: You can charge high prices for your products (high margins), or you can turn over your assets quickly.

Return on equity (ROE) is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity – in other words, it measures how good the company is at earning a decent return on the shareholder's money.

Analyzing a Company – Management

Excellent management can make the difference between a mediocre business and an outstanding one, and poor management can run even a great business into the ground. Your goal is to find management teams that think like shareholders – executives that treat the business as if they owned a piece of it, rather than as hired hands.

Executives' pay should rise and fall based on the performance of the company. [...] Firms with good corporate governance standards won't hesitate to pay managers less in bad times and more in good times, and that's the kind of pattern you want to see as a shareholder.

Avoiding Financial Fakery

Over time, increases in a company's cash flow from operations should roughly track increases in net income. If you see cash from operations decline even as net income keeps marching upward – or if cash from operations increases much more slowly than net income – watch out. This usually means that the company is generating sales without necessarily collecting the cash, and that's a very good recipe for a blowup down the road.

[...] firms that make numerous acquisitions can be problematic [...]. Aside from muddying the waters, acquisitions increase the risk that the firm will report a nasty surprise some time in the future, because acquisitive firms that want to beat their competitors to the punch often don't spend as much time checking out their targets as they should.

When inventories rise faster than sales, there's likely to be trouble on the horizon. Sometimes the buildup is just temporary as a company prepares for a new product launch, but that's usually more the exception than the rule. When a company produces more than it's selling, either demand has dried up or the company has been overly ambitious in forecasting demand. In any case, the unsold goods will have to get sold eventually – probably at a discount – or written off, which would result in a big charge to earnings.

Valuation – The Basics

Even the most wonderful business is a poor investment if purchased for too high a price. To invest successfully means you need to buy great companies at attractive prices.

Investors purchase an asset for less than their estimate of its value and receive a return more or less in line with the financial performance of that asset. Speculators, by contrast, purchase an asset not because they believe it's actually worth more, but because they think another investor will pay more for it at some point. The return that investors receive on assets depends largely on the accuracy of their analysis, whereas a speculator's return depends on the gullibility of others.

Over time, the stock market's returns come from two key components: investment return and speculative return. [...] the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas the speculative return comes from the impact of changes in the price-to-earnings (P/E) ratio. [...] over a long time span, the impact of investment returns trump the impact of speculative returns.

By paying close attention to the price you pay for a stock, you minimize your speculative risk, which helps maximize your total return.

The most basic ratio of all is the P/S ratio, which is the current price of the stock divided by sales per share. The nice thing about the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings.

The P/S ratio has one big flaw: Sales may be worth a little or a lot, depending on a company's profitability.

Although the P/S ratio might be useful if you're looking at a firm with highly variable earnings – because you can compare today's P/S with a historical P/S ratio – it's not something you want to rely on very much. In particular, don't compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.

Another common valuation measure is price-to-book (P/B), which compares a stock's market value with the book value (also known as shareholder's equity or net worth) on the company's most recent balance sheet. The idea here is that future earnings or cash flows are ephemeral, and all we can really count on is the net value of a firm's tangible assets in the here-and-now.

When the market was dominated by capital-intensive firms that owned factories, land, rail track, and inventory – all of which had some objective tangible worth – it made sense to value firms based on their accounting book value. After all, not only would those hard assets have value in a liquidation, but also they were the source of many firms' cash flow. But now, many companies are creating wealth through intangible assets such as processes, brand names, and databases, most of which are not directly included in book value.

Another item to be wary of when using P/B to value stocks is goodwill, which can inflate book value to the point that even the most expensive firm looks like a value. When one company buys another, the difference between the target firm's tangible book value and the purchase price is called goodwill, and it's supposed to represent the value of all the intangible assets – smart employees, strong customer relationships, efficient internal processes – that made the target firm worth buying. Unfortunately, goodwill often represents little else but the desperation of the acquiring firm to buy the target before someone else did, because acquiring firms often overpay for target companies. Be highly skeptical of firms for which goodwill makes up a sizable portion of their book value.

A company that's trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the P/E ratio. All else equal, it makes sense to pay a higher P/E for a firm that's growing faster, has less debt, and has lower capital reinvestment needs.

In general, comparing a company's P/E with industry peers or with the market has some value, but these aren't approaches that you should rely on to make a final buy or sell decision. However, comparing a stock's current P/E with its historical P/E ratios can be useful, especially for stable firms that haven't undergone major shifts in their business. If you see a solid company that's growing at roughly the same rate with roughly the same business prospects as in the past, but it's trading at a lower P/E than its long-term average, you should start getting interested.

Because risk, growth, and capital needs are all fundamental determinants of a stock's P/E ratio, higher growth firms should have higher P/E ratios, higher risk firms should have lower P/E ratios, and firms with higher capital needs should have lower P/E ratios.

When you're looking at a P/E ratio, you must be sure that the E makes sense. If a firm has recently sold off a business or perhaps a stake in another firm, it's going to have an artificially inflated E, and thus a lower P/E. Because you don't want to value the firm based on one-time gains such as this, you need to strip out the proceeds from the sale before calculating the P/E.

Don't rely on any single valuation metric because no individual ratio tells the whole story. Apply a number of different valuation tools when you're assessing a stock.

Valuation – Intrinsic Value

The value of a stock is equal to the present value of its future cash flows.

Companies create economic value by investing capital and generating a return. Some of that return pays operating expenses, some gets reinvested in the business, and the rest is free cash flow. We care about free cash flow because that's the amount of money that could be taken out of the business each year without harming its operations. A firm can use free cash flow to benefit shareholders in a number of ways. It can pay a dividend, which essentially converts a portion of each investor's interest in the firm to cash. It can buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and reinvest it in the business.

These free cash flows are what give the firm its investment value. A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we receive today. Why are future cash flows worth less than current ones? First, money that we receive today can be invested to generate some kind of return, whereas we can't invest future cash flows until we receive them. This is the time value of money. Second, there's a chance we may never receive those future cash flows, and we need to be compensated for that risk, called the "risk premium".

Value is determined by the amount, timing, and riskiness of a firm's future cash flows, and these are the three items you should always be thinking about when deciding how much to pay for a stock.

[...] the present value of a future cash flow in year n equals CFn/(1 + discount rate)^n.

If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value. Any valuation and any analysis is subject to error, and we can minimize the effect of these errors by buying stocks only at a significant discount to our estimated intrinsic value. This discount is called the margin of safety [...].

Putting It All Together

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The 10-Minute Test

With literally thousands of companies available to invest in, one of the toughest challenges for any investor is figuring out which ones are worth detailed examination and which ones aren't.

Does the firm pass a minimum quality hurdle? Avoiding the junk that litters the investment landscape is the first step in our 10-minute test. Companies with miniscule market capitalizations and firms that trade on the bulletin boards (or pink sheets) are the first ones to rule out. Also avoid foreign firms that don't file regular financials with the SEC [...]. Finally, recent initial public offerings (IPOs) are usually not worth your time. Companies sell shares to the public only when they think they're getting a high price, so IPOs are rarely bargains. Moreover, most IPOs are young, unseasoned firms with short track records. The big exception to this rule is firms that are spun off from larger parent companies.

Has the company ever made an operating profit? This test sounds simple, but it'll keep you out of a lot of trouble. Very often, companies that are still in the money-losing stage sound the most exciting [...] Unfortunately, stocks like this will also blow up your portfolio more often than not. They usually have only a single product or service in the pipeline, and the eventual viability of the product or service will make or break the company.

Does the company generate consistent cash flow from operations? Fast-growing firms can sometimes report profits before they generate cash – but every company has to generate cash eventually. Companies with negative cash flow from operations will eventually have to seek additional financing by selling bonds or issuing more shares. The former will likely increase the riskiness of the firm, whereas the latter will dilute your ownership stake as a shareholder.

Are returns on equity consistently above 10 percent, with reasonable leverage? Use 10 percent as a minimum hurdle. If a nonfinancial firm can't post ROEs over 10 percent for four years out of every five, for example, odds are good that it's not worth your time. For financial firms, raise your ROE bar to 12 percent.

Is earnings growth consistent or erratic? The best companies post reasonably consistent growth rates. If a firm's earnings bounce all over the place, it's either in an extremely volatile industry or it's regularly getting shellacked by competitors.

How clean is the balance sheet? Firms with a lot of debt require extra care because their capital structures are often very complicated.

Does the firm generate free cash flow? [...] Generally, you should prefer firms that create free cash to ones that don't and firms that create more free cash to ones that create less. [...] The one exception – and it's a big one – is that it's fine for a firm to be generating negative free cash flow if it's investing that cash wisely in projects that are likely to pay off well in the future.

How much "other" is there? Companies can hide many bad decisions in supposedly one-time charges, so if a firm is already questionable on some other front and has a history of taking big charges, take a pass.

Has the number of shares outstanding increased markedly over the past several years? If so, the firm is either issuing new shares to buy other companies or granting numerous options to employees and executives. The former is a red flag because most acquisitions fail, and the latter is not something you want to see because it means that your ownership stake in the firm is slowly shrinking as employees exercise their options. [...] However, if the number of shares is actually shrinking, the company potentially gets a big gold star. Firms that buy back many shares are returning excess cash to shareholders, which is generally a responsible thing to do.

A Guided Tour of the Market

Over the long haul, a big part of successful investing is building a mental database of companies and industries on which you can draw as the need arises.

Health Care

Health care firms benefit from consistent demand. Even when the economy is in the tank, people still get sick and need doctors and hospitals. As a result, the health care sector has traditionally been a defensive safe haven.

Health care companies often benefit from economic moats in the form of high start-up costs, patent protection, significant product differentiation, and economies of scale. This makes it tough for new players to enter the market, particularly for drug companies with valuable patent rights, managed care organizations with large provider networks, or medical device firms with long clinical track records. These characteristics make for great profitability [...].

Size is another barrier to entry for drug companies. Developing a single drug can take 15 to 20 years to get through the entire research, development, and regulatory process and can cost hundreds of millions over that time frame.

Brand name drugs enjoy patent protection for 20 years from the date the company first completes the patent application. However, because a patent application is usually filed as soon as a drug is identified and not when it hits the market, drugs rarely enjoy 20 years of monopoly profits because a significant portion of the protected period is eaten up by trials and the approval process. Many drugs enjoy only 8 to 10 years of patent protection after they are launched in the marketplace.

Generic drug makers can charge much less because they don't have to recoup the $800 million in per drug research and development costs.

If you're considering buying shares in a drug company that depends on a specific drug for a significant percentage of its sales, don't bank on the money continuing to come in after the patent expires.

Drugs that treat conditions affecting a large percentage of the population typically have better potential than niche products. So do drugs that treat chronic conditions, because patients must continue taking the medication to stay healthy.

It might sound strange to view megablockbuster drugs as a negative, but they can become a disadvantage. If a drug's revenues become a large enough piece of the pie, a company's fate can be linked too heavily to that drug. Because that drug will eventually lose its patent protection, we think it's wise for investors to account for the single-product risk by demanding a slightly larger margin of safety.

Although the best biotech companies can generate enormous free cash flow [...] most are too speculative for all but the most aggressive investors. Picking successful firms requires a bit of skill, some understanding of the science, and a lot of luck.

As with the other health care sectors, the aging population and increase in life expectancy will drive sales growth in medical devices.

In addition to their attractive growth characteristics, device companies also typically boast wide economic moats. Economies of scale, high switching costs, and long-term clinical histories all serve as high barriers to new entrants.

Device firms are not without risk. Product cycles can be very short, so companies must spend heavily on research and development to keep up with their competitors.

Insurance and managed care firms are subject to intense regulatory pressure and widespread litigation, making them somewhat less attractive than some other health care industries. They typically don't have wide economic moats.

Consumer Services

The only way a retailer can earn a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors'. It can do this by offering unique products or low prices. The former method is tough to do on a large scale because unique products rarely remain unique forever.

Because many consumer purchases other than food are discretionary (can be put off for later), it's not surprising that retail stocks generally outperform during periods of economic strength and underperform during times of economic weakness.

Demographic shifts and changes in the workforce make the long-term outlook for restaurants pretty bright. Eating food prepared by restaurants is becoming a more attractive alternative to home meal preparation – with both parents working in many households, there's little time to cook and even less for grocery shopping and cleanup. The economics of meal preparation are shifting in favor of eating out as well because families are getting smaller.

One of the best ways to distinguish excellent retailers from average or below-average ones is to look at their cash conversion cycles. The cash cycle tells us how quickly a firm sells its goods (inventory), how fast it collects payments from customers for the goods (receivables), and how long it can hold on to the goods itself before it has to pay suppliers (payables).

If days in inventory and days in receivables illustrate how well a retailer interacts with customers, days payable outstanding shows how well a retailer negotiates with suppliers. It's also a great gauge for the strength of a retailer.

Business Services

Because the business services sector is so varied, we divide it into three major subsectors based on how companies set up their businesses to make money. Specifically, we look at technology-based, people-based, and hard-asset-based subsectors.

Outsourcing makes sense to many business owners because it usually saves time and money, removes the hassle of dealing with noncore tasks, and allows management to focus on what's really important to the success of their company.

In business services, size does indeed matter. Companies can leverage size to boost both their top and bottom lines. By expanding the range of services offered, companies can increase total revenue per customer. By handling more volume – especially over fixed-cost networks – companies can lower unit costs and achieve greater profitability.

Size impacts the industry through branding as well. Often, brands play a major role in a business outsourcing purchase decision.

In general, technology-based businesses [...] require huge initial investments to set up an infrastructure that can be leveraged across many customers. These huge investments are a barrier to entry for new competitors.

Another desirable characteristic of technology-based businesses is the low ongoing capital investment required to maintain their systems. For firms already in the industry, the huge upfront technology investments have already taken place.

As a result of the high barriers to entry into technology-based businesses and long-term customer contracts, firms in this subsector tend to have wide, defensible moats.

The people-based subsector includes companies that rely heavily on people to deliver their services, such as consultants and professional advisors, temporary staffing companies, and advertising agencies. Investments can be attractive at the right price, but the model is generally less attractive than that of the technology-based subsector.

Brands, longstanding relationships with customers, and geographic scope can provide some advantages relative to competitors. But within most people-based industries, there are usually multiple competitors with similar strengths in these areas, and they tend to compete aggressively with one another.

Companies in the hard-asset-based subsector depend on big investments in fixed assets to grow their businesses.

Banks

[...] the heart and soul of banking is centered on one thing: risk management. Banks accept three types of risk: (1) credit, (2) liquidity, and (3) interest rate, and they get paid to take on this risk.

One of the biggest challenges to investing in banks is spotting credit quality problems before they blow up in investors' faces. To help avoid getting stuck with a bank that blows up, investors should pay close attention to charge-off rates and delinquency rates, which are seen as an indicator of future charge-offs.

Beware of super-fast growth. It's an axiom in the financial services industry that fast growth can lead to big troubles. Fast growth is not always bad – many of the best players have above-average growth rates – but any financial services company that's growing significantly faster than competitors should be eyed with skepticism.

Asset Management and Insurance

With huge margins and constant streams of fee income, asset managers are perennial profit machines. However, these companies are so tied to the markets that their stock prices often reflect oversized doses of the current optimism or pessimism prevailing in the economy, which means it pays off to take a contrarian approach when you're thinking about when to invest.

Asset management firms run money for their customers and demand a small chunk of the assets as a fee in return. This is lucrative work and requires very little capital investment. The real assets of the firm are its investment managers, so typically compensation is the firm's main expense. Even better, it doesn't take twice as many people to run twice as much money, so economies of scale are excellent.

The single biggest metric to watch for any company in this industry is assets under management (AUM), the sum of all the money that customers have entrusted to the firm. Because an asset manager derives its revenue as a percentage of assets under management, AUM is a good indication of how well – or how badly – a firm is doing.

Investors should look for asset management companies that are able to consistently bring in new money and don't rely only on the market to increase their AUM. Look for new inflows (inflows higher than outflows) in a variety of market conditions. This is a signal that the asset manager is offering products that new investors want and that existing investors are happy with the products they have.

Given the commodity-like products of the life insurance industry, it is next to impossible for one insurer to successfully grow – without acquisitions – above the industry's long-term annual revenue growth rate.

Software

Because technology buyers are inherently conservative and loath to buy products from a vendor that might go out of business and leave them stranded for basic service, companies are increasingly buying only from industry leaders.

Like database software, the ERP market isn't growing very fast because most large companies already have some type of ERP system installed.

Often, companies that dominate a smaller niche are more attractive investments than household names that serve larger markets.

License revenue is the best indication of current demand because it represents how much new software was sold during a given time. It's a very profitable source of revenue because software can be produced for almost nothing after it has been developed. Service revenue, which is the other major type of revenue that many software firms report, is less profitable because it's expensive to employ consultants to install software.

The low barriers to entry of the software industry contrast with high barriers to success – it's easy to start up a software firm, but it's much more difficult to create one that's still around after several years. Thus, look for software companies that have thrived during multiple business cycles and have solid results during both the peaks and valleys of IT spending.

The software industry is highly cyclical, with sales hinging on economic conditions and IT spending. The problem is that in good times software companies thrive, and in bad times they're some of the hardest hit. The primary reason for this cyclicality is that many corporations view software as a discretionary purchase that can be deferred in tough times. In other words, when the economy and business suffer, cutting IT spending is a quick way to buffer profit declines.

Hardware

The environment in the hardware sector makes it fiendishly difficult to build a sustainable competitive advantage because technological advances and price competition mean that the lion's share of hardware's benefits are passed to consumers, not the company creating the products.

In the hardware industry, network effects can arise because hardware often needs (1) to operate with other hardware and (2) to be maintained by people. The more a certain product becomes prevalent, the more other hardware needs to take heed of the product's characteristics and the more people (and time) are invested in learning to operate the product.

Media

Media companies generate cash by producing or delivering a message to the public. The message, or content, can take several shapes, including video, audio, or print.

Companies that rely on one-time user fees sometimes suffer volatile cash flows because they're heavily affected by the success of numerous individual products, such as newly released films or novels. While having a string of hits can result in a bonanza for the firm, the converse is also true: Several flops in a row can lead to disaster. This uncertainty can make it difficult to forecast future cash flows.

Subscription-based businesses are generally more attractive than one-time user fee businesses because subscription revenue tends to be predictable, which makes forecasting and planning easier and reduces the risk of the business. There is another advantage to subscriptions: Subscribers pay upfront for services that are delivered at a later date.

Companies with advertising-based models can enjoy decent profit margins, which are often enhanced by high operating leverage. The reason for the high operating leverage is that most of the cost in an advertising-based model is fixed. [...] However, advertising revenue streams can be somewhat volatile – advertising is one of the first costs that company executives cut when the economy turns south, which is why advertising revenue growth tends to move with the business cycle.

Media firms enjoy a number of competitive advantages that help them generate consistent free cash flows, with economies of scale, monopolies, and unique intangible assets being the most prevalent. Economies of scale are especially important in publishing and broadcasting, whereas monopolies come into play in the cable and newspaper industries. Unique intangible assets such as licenses, trademarks, copyrights, and brand names are important across the sector.

Telecom

The telecom sector is filled with the kinds of companies we love to hate: They earn mediocre (and declining) returns on capital, economic moats are nonexistent or deteriorating, their future depends on the whims of regulators, and they constantly spend boatloads of money just to stay in place. [...] Because telecom is fraught with risk, we typically look for a large margin of safety before considering any telecom stock.

Consumer Goods

The consumer goods sector is composed of industries such as food, beverages, household and personal products, and tobacco. Like anything large and old, it also moves slowly: Consumer goods markets typically grow no faster than the gross domestic product and sometimes even slower. Despite this slow growth, consumer goods stocks tend to be solidly profitable, fairly steady performers, which can make them excellent long-term holdings for your portfolio.

Consumer goods companies generate profits the old-fashioned way: They make products and sell them to customers, usually supermarkets, mass merchandisers, warehouse clubs, and convenience stores.

The handful of giant firms that dominate each consumer goods industry enjoy such massive economies of scale that it would be virtually impossible for a small new entrant to catch up.

The networks that manufacturers use to get their products on to shelves in the stores can be another competitive advantage that is very difficult for competitors to replicate.

Companies with brands that hold dominant market share are likely to stay in that position because shifts in share tend to be fairly small from year to year. Thus, whoever is number one right now is likely to remain in that position over the next several years.

Industrial Materials

The industrial materials sector includes a broad array of companies, which make everything from the fragrances used in soap to bulldozers and heat-seeking missiles. The general business model is simple: Industrial materials companies buy raw materials and facilities to produce the inputs and machinery that other firms use to meet their customers' expected demand for goods.

We divide industrial materials into two groups: (1) basic materials such as commodity steel, aluminium, and chemicals and (2) value-added goods such as electrical equipment, heavy machinery, and some specialty chemicals. The primary difference is that commodity producers have little or no influence on the price of the products they produce. Makers of value-added industrial materials, on the other hand, may be specialized enough or improve a customer's business enough for the manufacturer to share part of that benefit in the form of a premium price.

Although basic materials industries do have significant barriers to entry – the cost of constructing a new steel, aluminium, or paper processing plant is steep – stiff price competition makes for mediocre profits at best.

Energy

Although energy can be harvested from myriad sources – coal, nuclear, hydroelectric, wind, solar – nothing can come close to challenging the dominance of oil and gas as a source of energy.

The profitability of the energy sector is highly dependent on commodity prices. Commodity prices are cyclical, as are the sector's profits. It's better to buy when prices are at a cyclical low than when they're high and hitting the headlines.

Keep an eye on reserves and reserve growth because these are the hard assets the company will mine for future revenue.

Utilities

[...] utilities that provide electric service dominate the ranks of the publicly traded companies in the utilities sector. The electric utility business can be divided into essentially three parts: generation, transmission, and distribution.

[...] regulation is perhaps the single most important factor shaping the utility sector.

Regulated utilities tend to have wide economic moats because they operate as monopolies, but it's important to keep in mind regulation does not allow these firms to parlay this advantage into excess returns. In addition, regulation can (and often does) change.