Investing tips from Lynch, Graham, Buffett

10 December 2012 04:00 am Views - 4476

The long fierce bull faced by Sri Lankan equities, which brought yields down was due in part to fundamentally steady economic growth, rising profits and investor sentiment.

The Colombo bourse, which went through a strong correction phase during 2011 and 2012, currently carries ample opportunities for investors as equities now trade at bargain prices amidst anticipated growth prospects.

Hence,it would be better for the economy if savers piled their cash into equities now rather than wait for better news. The prudent investor faces a bargain opportunity as 113 counters currently trade at or below asset value thereby capturing a number of value picks.



Value investing
The Oracle of Omaha, Warren Buffet emphasized the importance of practicing value investing, “Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

Investors should thereby practice a cautious and patient approach by waiting for the right time to invest their savings, ideally a downturn where equities trade on discounted valuations compared with their comparative market counterparts.

Sri Lankan equities currently trade at attractive valuations in comparison to developed markets which ought to be of some comfort to investors, especially given higher growth prospects.

“Be greedy when others are fearful,” another famous quote by Warren Buffett illustrates a similar viewpoint where in a situation in which investors panic and flee out of the storm, the ideal approach should be to have a watchful eye and focus on the bargain hunt as investors’ choices will be guided by how they think the crisis will unfold.



The downturn in Sri Lankan stocks in 2011 and 2012 saw panic selling which accelerated the decline of the index. The overall decline for the index for 2011 stood at 8%, while the YTD dip in 2012 stood 12%.

Following the end of the three-decade-old civil war, Sri Lanka’s economic outlook has entered a high growth phase providing investors an ideal platform for investment. Sri Lanka’s FDIs and the strong net foreign inflow suggest the fact that foreigners have recognized this opportunity and been brave enough to step in with their capital, illustrating the confidence on the Sri Lanka’s growth prospects.

With valuations of the Sri Lankan market at an attractive level, compared to the frontier markets in the region reflects the ideal time to buy. But a few seem to make use of this opportunity.

According to investor, Bob Farrel, “The public buys the most at the top and the least at the bottom” which implies that a reversal in the trend is required to battle out the current market conditions.

Warren Buffet states, “I don’t look to jump over seven-foot bars: I look around for one-foot bars that I can step over” which depicts a bargain hunter approach.
During the years 2009 and 2010, the Sri Lankan equity market faced a steep upturn followed by strong sentiments leading to a speculative run in which retail investors played a dominant role, accounting for the greater proportion of participation. Simultaneously, significant foreign outflows and institutional selling was witnessed justifying that larger investors were prudent in their approach to investing by selling out at unreasonable valuations. Warren Buffet exemplifies that bad things aren’t obvious when times are good. “After all, you only find out who is swimming naked when the tide goes out.”

History is well stocked with bear markets that wiped out wealth on a vast scale in which those exposed to speculative counters are at a higher risk and hence, are prone to lose out more than those who thrive on fundamentally strong picks.In the Sri Lankan context, it could be seen that the true value of speculative counters are reflected at times of downturn as their market prices are not backed by fundamental valuations.



Long-term horizon
Equity investments are to be viewed with a long-term horizon.

“Someone’s sitting in the shade today because someone planted a tree a long time ago.”-Warren Buffet

Stock investing is not for making quick bucks, instead it is a long-term money making machine. The drive for investment is propelled by the desire to become financially independent and go on accumulating as much ‘assets’ as possible.

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Optimistic investors during the bull market paid higher valuations for equities generating higher returns and thus attracted more buying interest.

However, eventually investors have to face an inexorable logic, lower the yield, the lower the likely long-term return which applies to the current market condition, where a number of fundamentally strong counters trade at discounted valuations which generates ample choice for the pragmatic investor in picking high yielding counters.
Sri Lankan equities are currently trading in par with international equity markets resulting in foreign players placing significant confidence due to highly attractive valuations of the Colombo bourse.

The year 2012 encountered strong foreign participation steering the YTD net foreign inflow to surpass the Rs.36 billion mark. At such a time, where foreign investors are boldly stepping in and accumulating quality stocks, local participation continues at a dormant stage while retail investors remain on the sidelines.
“Investing without research is like playing stud poker and never looking at the cards.”

Peter Lynch’s investing philosophy illustrates that understanding the finances of the companies are vital before investing as consideration of liquidity is essential before an investor risks their money on it.

He states, “Behind every stock is a company. Find out what it’s doing.” By focusing on a few good companies, the investor is at a great advantage as he justifies that “It only takes a handful of big winners to make a lifetime of investing worthwhile.”

The concept behind Benjamin Graham’s intrinsic value is buying cash at a discount or at “net current assets”, whereby investors have nothing to lose. “If a common stock can be bought at no more than two-thirds of the working-capital alone—disregarding all other assets—and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money’s worth.”

Further, Graham’s investment principles place strong emphasis on investing in companies that pay dividends, preferring those with a 20-year history of steady payments. That way, Graham reasoned he would still earn a payday even as the market persisted in undervaluing his shares.

“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

This quote illustrates the importance of picking value stocks.

Further, he extends his views on price fluctuations as follows.“Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal.” Hence, price fluctuations are to be looked at as opportunities with a goal in mind.



Bottom line
In reality, investing in equity involves taking an ownership stake of a company, however small it is with a long-term perspective in mind. An investor needs to pay attention to the underlying rule of thumb ‘that is to invest only if those shares can be bought at a discount to the expected fair value’ of the underling company.
The total return i.e. dividend yield and capital gains yield, an investor should expect has to be within reasonable domain similar to a return one could expect from owning a company.

During the market bull run in 2009 and 2010, a vast segment of retail investors in Sri Lanka, driven by irrational exuberance were able to get very high returns by investing in the stock market. They did not bother to get a grasp of the fundamental value of a company nor question the underling rationale for the investment case purported by an investment advisor.

Similar to a herd mentality they blindly followed illiquid stocks that certain well-known names were buying (akin to house racing) with the hope that they can sell those shares at a higher price to a more gullible investor who is also lured by greed.

However, when reality takes its course, the price of all stocks which moved further and further away from their fair values falls and the bubble bursts in a similar fashion to what happened in all other markets.

It is time investors in Sri Lanka learn from the masters of investing the right way of investing in the stock market and refrain from following rumors with a herd instinct.

(This article was written by Imalka Hettiarachchi of Softlogic Stockbrokers (Pvt.) Ltd, with the auspices of the Research Committee of the Colombo Stock Brokers Association)