WELCOME TO THE WEALTH MANAGEMENT COURSE S G Raja Sekharan

EQUITY INVESTMENT Session 3

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WORLD’S WEALTHIEST FIVE - FORBES FEB 2010

Carlos Slim Helu –Mexico -$ 53.3 B – Mobile companiesWilliam Henry Gates –US - $ 53 B –MicrosoftWarren Buffet – US - $ 47 B –Berkshire HathwayMukesh Ambani –India $ 29 B – Reliance IndustriesLakshmi Mittal –UK -$ 28.7 B – Arcelor Mittal

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WARREN BUFFET –THE SAGE OF OMAHA One of the most

successful investors in the world

Noted for his adherence to “Value Investing”

Also known for his personal frugality

Born in 1930, second of three children, father was a stock broker and politician

Early in school age, he started earning by selling soft drinks and delivering paper

At 14 years, with his earning, he bought 40 acres of land –which he rented out

He went to Columbia for graduation - studied under Benjamin Graham –father of Value investing

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WARREN BUFFET –THE SAGE OF OMAHA Benjamin Graham

refused to hire him –saying Stock broking and Wall street was not for him

Warren Buffet came back –got married and stayed in Omaha with his father’s brokerage

Benjamin Graham changed his mind and gave him a job in his NY office

Value investing means seeking stocks selling at extraordinary discounts to the value of it’s underlying assets –defined as “Intrinsic value”

Buffet went a step beyond Value investing – he looked at the value of a good management team, product’s competitive advantage in marketplace

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WARREN BUFFET –THE SAGE OF OMAHA In 1956, he came back

to Omaha and launched Buffet Associates Ltd

In 1962, already a 30 year old millionaire –he joined forces with Charlie Munger

This collaboration eventually resulted in the investment philosophy of Value investing that helped Buffet to get where he is today

Along they way, they purchased a dying textile mill called Berkshire Hathaway - as a long term investment

Cash flows from this mill were used to fund other investments – eventually other investments overshadowed the textile business

In 1985, Buffet shut down the textile business – but continued with the company as a holding company

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WARREN BUFFET –THE SAGE OF OMAHA Buffet pick up stocks in what he believes are

well managed under valued companies When he purchases any stock – his intention

is to hold the stocks for infinite period of time Coke, Amex, Gillette etc are such stocks held

by him for many decades He also purchases companies outright and

let’s their management teams handle their day to day business

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WARREN BUFFET –THE SAGE OF OMAHA An investor and a businessperson should look

at a company in the same way. The businessperson wants to buy the entire company while an investor wants a part

The first question any businessperson will ask is, ‘‘What is the cash generating potential of this company?’’

Over time, there will always be a direct correlation between the value of a company and its cash generating capacity. The investor would benefit by using the same business purchase criteria as the businessperson

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WARREN BUFFET –HIS INVESTMENT PHILOSOPHY The basic idea of investing are to look at

stocks as business, use the market’s fluctuations to your advantage, and seek a margin of safety.

Warren Buffett seeks first to identify an excellent business and then to acquire the firm if the price is right

Once a good company is identified and purchased at an attractive price, it is held for the long-term until the business loses its attractiveness or until a more attractive alternative investment becomes available.

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WARREN BUFFET –HIS INVESTMENT PHILOSOPHY Buffett seeks businesses whose product or

service will be in constant and growing demand. In his view, businesses can be divided into two basic types: Commodity-based firms, selling products where

price is the single most important factor determining purchase. Buffett avoids commodity-based firms. They are characterized with high levels of competition in which the low-cost producer wins because of the freedom to establish prices. Management is key for the long-term success of these types of firms.

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WARREN BUFFET –HIS INVESTMENT PHILOSOPHY Buffett seeks businesses whose product or

service will be in constant and growing demand. In his view, businesses can be divided into two basic types: Consumer monopolies, selling products where

there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique.

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WARREN BUFFET – HOW DOES HE SPOT A COMMODITY BASED BUSINESS The firm has low profit margins (net income

divided by sales) The firm has low return on equity (earnings

per share divided by book value per share) Absence of any brand-name loyalty for its

products The presence of multiple producers The existence of substantial excess capacity Profits tend to be erratic The firm's profitability depends upon

management's ability to optimize the use of tangible assets.

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WARREN BUFFET – HOW DOES HE SPOT A CONSUMER MONOPOLY The firm has managed to create a product or

service that is somehow unique and difficult to reproduce by competitors due to

Brand name loyalty A particular niche that only a limited number of companies can

enter An unregulated but legal monopoly like patents

A strong upward trend in earnings Conservative financing A consistently high return on shareholder's equity A high level of retained earnings Low level of spending needed to maintain current

operations Profitable use of retained earnings

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WARREN BUFFET –HIS INVESTMENT PHILOSOPHY While Buffett is considered a value investor,

he passes up the stocks of commodity-based firms even if they can be purchased at a price below the intrinsic value of the firm. An enterprise with poor inherent economics often remains that way.

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WARREN BUFFET –HIS INVESTMENT PHILOSOPHY Investment in stocks based on their intrinsic

value, where value is measured by the ability to generate earnings and dividends over the years. Buffett targets successful businesses--those with expanding intrinsic values, which he seeks to buy at a price that makes economic sense, defined as earning an annual rate of return of at least 15% for at least five or 10 years.

WE WILL NOW GET INTO SPECIFICS There are 14 questions that we need to

answer We will take one corporate example –CRISIL

to understand the overall flow of thoughts

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q1Is it a consumer monopoly or commodity

business –does it have an identifiable durable competitive advantage?

Consumer monopolies typically have high profit margins because of their unique niche

Beyond high profit margins, look for companies with operating margins and net profit margins above their industry norms

Also look for strong earnings and high return on equity will also help to identify consumer monopolies.

Look at a detailed study of the firm's position in the industry and how it might change over time.

CRISIL – Yes –it is a pioneer, market leader and an well known brand in India

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q2Do you understand how the product

/service/business model works? Only invest in industries that you understand

– for example Buffet refused to invest in ecommerce companies during the dot com boom because he did not understand their business

CRISIL – Yes – corporates want their financial instruments rated –Crisil rates them and corporates use this rating to advertise their credibility.

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q3What is the chance that the product

/service/business model would be obsolete in the next 20 years?

Will there be a market for this product 20

years from now If there is going to be technological changes

envisaged, then will this company have an upper hand still?

CRISIL –rating is an expert’s job that cannot be automated. There will always be need for rating and corporates will need this service

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q4Does the company allocate capital

exclusively in the realm of expertise? Where have been their investments in the

past 5-10 years? Does the company stick with what it knows?CRISIL – Yes it does not seem to be spending

outside it’s area of expertise

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q5What has been the company’s EPS history

and growth rate The company must show a consistent growth

in EPS over the past 10 years Erratic growth and dips in EPS would mostly

make the company unattractive for investment unless there is a clear enough reason visible as to why it happened.

CRISIL’S EPS GROWTH RATE ( LAST 10 YEARS)

Mar '00

Mar '01

Mar '02

Mar '03

Mar '04

Mar '05

Dec '05

Dec '06

Dec '07

Dec '08

Dec '09

0

50

100

150

200

250

Earning Per Share (Rs)

Earning Per Share (Rs)

CAGR of EPS adjusted for shares issued for the period is - 27.8%

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q6Is the company consistently earning high

Return on equity The company must show a consistently high

ROE over the past 10 years – ROE = reported net profit /Net worth CRISIL – has an ROE ranging from 13.5% to

39.5% with an average ROE of 23%

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q7Is the company consistently earning high

Return on total capital? The company must show a consistently high

Return on total capital employed over the past 10 years

ROCE = Reported net profit /Total liabilities in BS

CRISIL – as they have no loans – the ROE and ROCE are the same and the average ROCE is 23%

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q8Is the company conservatively financed? Consumer monopolies tend to have strong

cash flows, with little need for long-term debt Screen for companies with no debt or low

debt – look at the interest coverage ratio –compare with industry peers

CRISIL – has no loans in it’s balance sheet – it is very conservatively financed

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q9Has the company been buying back its

shares? Buffett prefers that firms reinvest their earnings

within the company, provided that profitable opportunities exist. When companies have excess cash flow, Buffett favours shareholder- enhancing manoeuvres such as share buybacks

CRISIL – No -it has not yet bought back shares – in fact it has issued small amount of shares in the period 2003 to 2007

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q10Is the company free to adjust prices to

inflation? True consumer monopolies are able to adjust

prices to inflation without the risk of losing significant unit sales.

CRISIL – Yes – it can increase it’s prices as it is in a near monopoly market

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q11Does company need to constantly reinvest

in capital? Retained earnings must first go toward

maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better.

CRISIL –Really no - it’s business model depends on it’s credibility and quality of manpower employed and the knowledge retention – these do not need large amount of investments

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q12What is the initial rate of return (IRR) and relative

value to a Govt bond? EPS for the year divided by the long-term government

bond interest rate. The resulting figure is the relative value - the price that would result in an initial return equal to the return paid on government bonds.

We then have to look at the CAGR of the EPS as well. CRISIL – assuming a 8% govt bond rate – and based

on the current EPS of 212.43 – the relative value of govt bond would be –Rs 2655.37.

With the current share price of Rs. 6132 – the Crisil share gives a pretax return of 3.46% with the returns growing at 27.8% pa

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q13What is the projected share value and return on

investment using historical earnings growth rate: Calculate the CAGR of EPS for the past 10 years Calculate the average dividend payout ratio (DPS/EPS)

for the past 10 years Calculate the average PE for the last 10 years CRISIL – CAGR of EPS is 27.8% Average Dividend payout ratio is 33.95% Average PE for the last 10 years has been – 20.55

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q13What is the projected share value and return on

investment using historical earnings growth rate: Calculate the EPS for the next 10 years as follows:

EPS of year 2 = EPS of year 1 * CAGR of EPS

Calculate the dividend payout for the next 10 years as follows:Dividend payout for year 2 =EPS for year 2 * average DP ratio

Calculate the sum of all the dividends paid for the next 10 years

CRISIL –HISTORICAL EARNINGS GROWTH RATE METHOD

Historical Earnings growth rate:

Year EPS DPS

2010 212.43 72.12

2011 271.49 92.17 2012 346.96 117.79

2013 443.41 150.54

2014 566.68 192.39 2015 724.22 245.87

2016 925.55 314.23

2017 1182.86 401.58 2018 1511.69 513.22 2019 1931.94 655.89 2020 2469.02 838.23

Total 3594.03

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q13What is the projected share value and return on

investment using historical earnings growth rate: Projected share price at 10th year = EPS at 10th year *

Average PE ratio

Total estimated gain at the end of 10th year = Projected share price at 10th year + Sum of all dividends for 10 years

Calculate the CAGR of your investment in 10 years – FOR CRISIL THIS IS 24.37%

CRISIL –HISTORICAL EARNINGS GROWTH RATE METHOD

Historical Earnings growth rate:

Year EPS DPS

2010 212.43 72.12 Eps after 10 years 2469.02

2011 271.49 92.17

Sum of dividends

for 10 years 3594.03

2012 346.96 117.79

2013 443.41 150.54

Projected share price

is 2020 50725.99

2014 566.68 192.39

Total gain including dividends 54320.02

2015 724.22 245.87

2016 925.55 314.23

current price of share 6132

2017 1182.86 401.58 CAGR of

investment 24.37%2018 1511.69 513.22 2019 1931.94 655.89 2020 2469.02 838.23

Total 3594.03

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q14What is the projected share value and

return on investment using sustainable growth rate:

Calculate the average PE ratio for the past 10 years -20.545

Calculate the average ROE for the past 10 years -23%

Calculate the average dividend payout ratio for the past 10 years – 33.95%

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q14What is the projected share value and return on

investment using sustainable growth rate:Calculate the Book value of the share for the next 10 years

using the formula: BV for year 2 = BV for year 0 + Retained earnings for year 1 Retained earnings for year 1 = Projected EPS for year 1–

Projected Dividend Payout for year 1 Projected EPS for Year 1 = average ROE * BV for Year 0 Projected dividend payout for year 1 =

EPS for year 1* average Dividend payout ratio for past 10 years

SUSTAINABLE GROWTH RATE MODELSustainable growth

rate model

Year BVPS EPS DPSretained earnings

2010 570.56 131.23 44.55 86.68

2011 657.24 151.16 51.32 99.84

2012 757.08 174.13 59.12 115.01

2013 872.09 200.58 68.10 132.48 2014 1004.58 231.05 78.44 152.61

2015 1157.19 266.15 90.36 175.79

2016 1332.98 306.59 104.09 202.50 2017 1535.48 353.16 119.90 233.26 2018 1768.74 406.81 138.11 268.70 2019 2037.44 468.61 159.09 309.52 2020 2346.96 539.80 183.26 356.54

Total 1096.34

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QUESTIONS TO DETERMINE THE ATTRACTIVENESS OF BUSINESS – Q14What is the projected share value and return

on investment using sustainable growth rate: Calculate the EPS for year 10 Calculate the expected Share Price for year 10 =

EPS (FY10)* Average PE To this share price estimate, add the estimated

dividends paid for the next 10 years Calculate the expected CAGR of your investment

today

SUSTAINABLE GROWTH RATE MODELSustainable growth

rate model

Year BVPS EPS DPSretained earnings

2010 570.56 131.23 44.55 86.68 EPS in 2020 539.80

2011 657.24 151.16 51.32 99.84 Average PE

ratio 20.545

2012 757.08 174.13 59.12 115.01 Share price

in 2020 11090.21

2013 872.09 200.58 68.10 132.48 Add

dividend 12186.552014 1004.58 231.05 78.44 152.61

2015 1157.19 266.15 90.36 175.79 Current

share price 6132

2016 1332.98 306.59 104.09 202.50 CAGR of

investment 7.10%2017 1535.48 353.16 119.90 233.26 2018 1768.74 406.81 138.11 268.70 2019 2037.44 468.61 159.09 309.52 2020 2346.96 539.80 183.26 356.54

Total 1096.34

Wealth management courseSession 1 Overview of Financial planning and Wealth

managementSession 2 Equity, Debt, Mutual funds.

Session 3 Equity, Debt, Mutual funds (continued)

Session 4 Insurance, Derivatives, BullionSession 5 Real Estate, Private Equity, Venture CapitalSession 6 Macro Economics -Monetary and Fiscal policies,

Inflation and interest rateSession 7 Tax planning, Retirement planning, Estate planning

Session 8 Wealth management Industry in India and relationship management as a career

Session 9 Executive interactionSession 10 Final wrap up

THANK YOU