A Fundamental Approach to the Purchase of Stocks

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A “Fundamental” Approach to the Purchase of Stocks for the Average Investor

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2013 Edition

SIAE Patent n. 201202813 Year of the copyright: 2013 Note of the copyright: by Antonio Sferra. All rights reserved.

Information above form this note of the copyright: © 2013 by Antonio Sferra. All rights reserved.

ISBN

978-1-291-14996-8

DISCLAIMER: Notwithstanding the care to provide the best possible information on the stocks and companies analyzed, trend of stock prices is dependent to changing conditions, which must be assessed and taken under direct responsibility by the individual investor. So in no event shall the author be held liable for an unsatisfactory result, as all returns shown are not a guarantee of future performance, and result of calculations on data of companies analyzed that could change in a positive or negative way in the future. Thus the investor using this text is aware of analyses and data and, when decides on his or her own to invest in one of the stocks recommended here, bears the full responsibility of the investment decisions made.

All data refer to prices and financial values on May 2013 which may have changed at the time of reading the book. The work must be evaluated in its systematic knowledge and not regarding any particular chart, price or balance sheet item. Finally, the book adopts an open view to all international markets and in particular the American one.

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Contents

PREFACE .....................................................................5 WHAT DOES “FUNDAMENTAL” MEAN? ..................................9 DISTINCTION BETWEEN INVESTMENT AND SPECULATION .........11 HOW TO MOVE YOURSELF IN THE MESS OF INFORMATION ABOUT FINANCIAL MARKETS .....................................................15 BUILDING OF OUR INVESTMENT SYSTEM .............................21 CONSIDERATIONS ABOUT SIZE ..........................................51 ABOUT DIVIDENDS .......................................................53 A POSSIBLE INDEX TO RANK STOCKS ..................................59 HOW TO COMPOSE YOUR OWN STOCK PORTFOLIO .................68 IMPORTANCE OF OWNERSHIP OF STOCKS FOR LONG PERIODS ..79 A POSSIBLE GUARANTEE AS PROTECTION TO YOUR PORTFOLIO .83 AN EXAMPLE OF FORCED EXIT: NOKIA ................................89 ADDITIONAL THOUGHTS .................................................93 THE PHILIP MORRIS “CASE” ...........................................101 THE CASE OF NEGATIVE EQUITY......................................107 ABOUT SALES ............................................................113 A “QUALITATIVE” INTEGRATION TO OUR SYSTEM .................117 ABOUT CURRENCY ......................................................121 ADVANTAGES OF STOCKS WHEN COMPARED TO FUNDS ..........123 WHAT STOCKS TO BEGIN TO ANALYZE ...............................125 STEP BY STEP ANALYSIS OF A STOCK ...............................129 HOW TO EVALUATE IPOS (INITIAL PUBLIC OFFERINGS) – THE FACEBOOK CASE .........................................................135 !3

DEVELOPMENT OF A SOFTWARE FOR OUR INVESTMENT SYSTEM ...

139 PURCHASING STOCKS ON THE INTERNET BANKING ...............147 CONCLUSIONS ............................................................149 ABOUT THE AUTHOR....................................................151 APPENDIX - RANKINGS ON MAY 2013 OF THE MOST INTERESTING STOCKS IDENTIFIED .....................................................153

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Preface

The main goal of this work is to try to shed light on a matter, finance, and stock markets in particular, which is often presented in a more complex way than it actually is. The amount of information available on the subject is so huge that, without selecting what is really important, it is impossible to arrive to a real effective investment system.

What is presented here is a synthesis of the knowledge the author has gathered by himself, starting from the works by Benjamin Graham ("The Intelligent Investor" in particular, but also "Security Analysis" and “The Interpretation of Financial Statements�), critically observing the moves of the greatest investor of all time - Warren Buffett - and adding and proposing some original ideas the author himself did not find in any other book of finance, newspaper or other.

As said, what cares the author in particular is having created a system, a point of reference, a set of rational principles to guide the average investor in the choice of an own portfolio of stocks. No initial knowledge is required on the matter, the content is explained in a simple way, avoiding useless technicalities, and also the unaware investor will not find it impossible to follow the content of the book. A good number of examples is presented, so that it results also in a practical guide, not a mere theoretical work.

It is important to note that this is a guide for investing in stocks, not in other financial instruments such as derivatives, bonds or other, although some principles and concepts can be applied to investments in general. We believe that investing in stocks offers the best opportunities of gains, especially in a multi-decade period of low interest rates and therefore low-yield fixed rate !5

from “safe” financial instruments. Of course, the likelihood of making mistakes for the unaware or ill-advised investor is much higher in the equity markets versus bonds or government bonds, but at the same way the opportunity for an aware investor to obtain uncommon returns is much higher too.

The big difference between stocks and alternative financial instruments at fixed rates is that performance of stocks is only hypothetical and therefore not certain, except what regards future dividends already declared payable by the underlying company, but with regard to the revaluation of the share price only predictions can be made, there is no guarantee of return. Obviously, however, in the case of fixed-income investments, the certainty of returns is paid at the dear cost of smaller returns in the latter than equities.

For example, in our days you are lucky if you can find no-junk fixed-rate instruments that offer a fixed annual return of gross 5%, while on the contrary, the best stocks we were able to find among multinational companies in 2012 offered an annual return even greater than 30% from the revaluation of the share price alone, not to consider dividends that are paid every certain periods of time and whose performance depends on the purchase price of the stocks. Of course, the difficulty is to determine whether the best stocks of 2012 will offer the same performance in the next years: no contract guarantees that this year we will have the same returns. The companies may suddenly suffer a contraction in the volume of business, and so record a drop in their share prices. What can allow us to make predictions in this regard? This is exactly the aim this book will try to achieve.

The main feature of stocks is to possess the potential to achieve: • •

a capital appreciation in terms of an increase in the price of the stock a return under the form of dividends

it is in a sense similar to investing in a real estate property in which you have two ways to get a return: • the increase in the value of the property from the original price paid • a monthly rent But stocks have the great advantage of being bought and sold in less time and with fewer constraints than houses and to be more flexible. You can buy a stocks in just a few seconds, while buying a house may require even months.

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Moreover, through stocks you can invest in different economic sectors, not only in real estate, allowing you to diversify the investment risk. If you want to invest in real estate, however, various stocks of companies operating in that field are available.

If the reader is not convinced of the goodness of stocks before starting to read this book, we are confident that at the end of the book he or she will at least be more inclined to consider also this possibility, also because we want to make it clear at the end of the text that stocks are not all the same. Often we hear about the stock exchange in general terms: "the stock market is going well", "should give up the stock market and buy gold", etc.. In fact we will see that whether the stock market goes well, whether it goes wrong, there are always stocks that are good and stocks that go wrong, companies that make good use of capital and companies that squander it, companies that make profits and companies that are always in deficit, stocks that are undervalued and stocks that are overvalued.

We believe, in fact, that investing in stocks offers at least the hope of improving the own social position, which is not the case for fixed-income investments, through which, during periods of low interest rates, it is possible to maintain at the best the purchasing power against inflation. So those who invest in equities (i.e. stocks) in general are driven by a desire for profits above the norm and to improve their financial condition, while those who invest in fixed rate are quite willing to maintain as they can what earned with their own work, thus minimizing the risk of dispersion of their capital.

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What does “Fundamental� mean?

The two main ways to analyze stocks are the fundamental analysis and the technical analysis.

The fundamental analysis judges the quality of an investment in stocks analyzing the financial data of the company underlying the stock, its future prospects in terms of business, the judgment of the company by different stakeholders that register an interest in the company and so on. It does not worry about the market reactions on certain stock prices, but considers only values underlying the stock, future sustainability and consistency of results. It uses financial data of the past in particular and tries from these to make predictions about the future performance of the business and consequently of the stock price. For example, by analyzing financial data of previous years, the investor attempts to predict how financial values will evolve and how the stock price is consequently affected, while analyzing the views of stakeholders in the company, tries to figure out if it is worth investing in it for the future, if it may be sustainable, reliable, well-managed, stable and so on. The fundamental investor analyzes the company underlying the stock, not the stock per se or the movements of its price, and invests in that stock only if she thinks it is worth investing in the underlying company.

The technical analysis, on the other hand, studies the movements of the market in the past, in terms of stock prices, amount of trade activity, trend over time, trying to predict what is going to happen in the short or medium term to the price itself. It works with price charts in particular, trying to predict from the charts of the past how the price will move in the future. Very !9

popular concepts that are used for this purpose are the support and resistance lines, which are drawn by joining points of minimum and maximum respectively; said in a simple way, if the price overcomes a support line the stock must be sold, if it is above a resistance line it must be purchased! We believe that this is the maximum knowledge the reader should possess of the subject, that is, just knowing that such a theory exists. In Figure 1 you will find an example of the charts used. The main drawback of technical analysis we believe is that most of the time the investor is pushed to buy a stock just because its price has exceeded a resistance line, only to experience that after buying, it falls back below the same line forcing to sell it. Anyway, with technical analysis you cannot really justify why you are buying a stock or why you are selling it.

The present work is clearly a "fundamental" one, it adopts the fundamental analysis and no interest is devoted to the technical one. We believe that adopting the former provides the investor with a solid knowledge in order to understand and predict the market, while the latter is nothing more than a system for betting on the future.

With this first selection in your mind you are already in a position to make a first, large selection of what is relevant and what is not. Do not consider all the technical analysis and you have already reduced the amount of information for analysis of a first 50%!

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Figure 1 - An example of Technical Analysis

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Distinction between investment and speculation

Probably billions of words have been spent on this difference. However we try to add our own.

Investing in a stock means entering in the capital of the underlying company.

Listed companies have their capital split into a certain number of shares, a portion of which is traded on the stock markets. So, regardless of the principal shareholders, who own the majority of total shares of the company, a portion of the shares is put into markets (stock markets) and exchanged between a number of investors around the world. So, when you adopt an investment strategy, you clearly realize that when you buy a stock, you are putting your money in the capital of the company buying pieces of company which are the shares, from which you expect a return, in terms either of an increase in the value of capital (i.e. an increase in stock price) or the payment of dividends every certain period of time or both. Investing in a stock is only the final part of a job of analysis done previously that has convinced us that the company is potentially a worthwhile investment. In general terms, the investor has at least a medium-term perspective, the more likely a long-term one, convinced as she is of the goodness of her choice for the years to come.

It is also likely that the investor will remain in the market even during periods of crisis of the stock markets, convinced as she is that in the long term her choice will be rewarded.

Speculation, on the contrary, consists in trying to obtain a more immediate return from the stock trading. So the speculator will remain out of the market !11

for certain periods and enter only when she thinks that an immediate increase in the stock price is going to happen. The speculator does not care about the goodness of the investment in the long run, what matters to her is that, from the news available, the stock could register an increase in the immediate future.

It is likely that the speculator will face many more purchases and sales compared to an investor, which is the reason why bank charges play an important role in the final return. Finally, she is likely to move from the simple purchase of stocks to derivative financial instruments that are capable of imparting a leverage to the investment (among them, movements “at the margin” that allow you for example to purchase shares at the price of € 10.000 only disbursing € 1.000, with the remaining € 9,000 provided by the bank on which interest shall be paid with each passing day - the moment in which the losses were to exceed € 1,000 initial bank automatically closes the position).

This is only reasonable for short-term investments, because each day that passes more and more interests are paid: for this reason, derivative instruments are not appropriate for an investor, except when one wants to protect (hedge) the primary investment with additional guarantees. But this topic is beyond the scope of this work.

A further difference in behavior between the two categories of the investor and the speculator is noted in relation to the payment of dividends. For the investor the dividend payment is the natural consequence and result of a good investment, and she does not need to purchase one stock only in the proximity of the payment of dividends, indeed not even knows the exact date of the payment of these. In fact, she will not sell the stock immediately after having received the dividends, something that instead does the speculator. The latter will buy the stock only in the proximity of the payment of dividends and sell even before the payment of dividends, but immediately after the record date in which the holders of shares are recorded as being entitled to the dividend.

It is therefore essential to the speculator to know the exact record date to sell immediately after. The investor, on the contrary, does not care about this aspect, which he or she considers marginal.

This work is clearly for the investor in stocks. You will find in this book that often the terms "stock" and "company" are used almost interchangeably, because for us to buy shares means buying parts of companies! Moreover it belongs to a way of investing known as “Value Investing”, i.e. investing in a stock only if its price is significantly below the real value of the company. This theory, for which Buffett is considered the main example together with his teacher Benjamin Graham, is based on the assumption that it does not exist a bad or good stock, but all depends on the purchase price. A company must !12

not be bought at any price, but only at a bargain price. So a value investor has not to expect an immediate return on the investment made, but be aware that the price at which the stock has been bought is significantly lower than a fair price so that this can translate sooner or later in a significant increase in the near or long future. Furthermore this method does not predict exact values for the right price of a stock or the exact timeliness of price evolution in the future. It only can say you that you are buying at significantly convenient prices or can let you understand how more or less a value of a company could evolve. So in the remaining of the book only rough estimates and calculations will be made. At the end of the book, for example, you will not be able to say that a stock is selling at $ 4.56 while it should sell at $ 4.73 in a certain date; what you will be able to predict is: this stock is selling near $ 3, while it should sell also at $ 15. The stock at this price could be a good bargain in the near or long future, but you will never be able to say: at this date the stock price will exchange at these dollars. So one of our basic concepts is: you cannot predict the evolution of stock prices in the future, you can only buy at low prices expecting that the market sooner or later will recognize its misjudgment and consequently correct the price.

Keep in your mind this further difference between investment and speculation, and the concept of value investing and you have made another important selection among the remaining information to be analyzed.

You may have noticed, too, that the title of our book contains in it a reference to a particular type of investor: the average investor. Our segmentation of the population of investors in stocks is as follows: •

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Classic investor: relies on specialized financial advisors or bank for advice on which stocks to buy. She trusts the advice and provides to the purchase without analyzing if the recommended stocks are valid Average investor: has some basic knowledge of the stock markets and seeks to gather information on the stocks themselves either using the technical analysis or the fundamental one or simply basing the purchase on "rumors" of the moment. She comes in autonomy to decide which stocks to buy and how to put together her own portfolio Expert investor: has received specific training on the stock markets, is probably an independent financial advisor or works as a promoter of financial instruments. She performs analysis of information not accessible to the average investor applying even complex theories derived from mathematical analysis.

In theory, an expert investor should be able to obtain better returns when compared to the other two categories, but it is not always so. Or rather, she will probably get higher returns than investors in the first category who are those which she herself recommended, but not necessarily will be able to beat the returns of investors in the second category.

So as specified in the title, our book is intended for investors who are considered in the second type listed: the average investor.

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How to move yourself in the mess of information about financial markets

Finance plays such an important role in today's world that each newspaper contains a number of pages dedicated to the subject every day, many of them are specific for the financial world and websites on the subject are countless, not to mention books. Works that explain tons of formulas, using the most complex mathematical operators, just to look for an explanation of what moves the market.

For the average investor probably the most difficult task is to make a selection of what is really relevant to her purpose and to avoid even considering the 99% of useless information on the subject. Omit the technical analysis and you have already completed 50% of the work, build an opinion by yourself and you have done the rest.

As mentioned, we believe that the essential point is to build the opinion on a stock by ourselves, without accepting evaluations by others: this can be done, however, only if you possess the minimal tools available, and it is precisely what this text aims to provide.

In the Internet era the main source of information is the website of a company, where you can find all the relevant information and the historical annual or partial (half-yearly and quarterly) financial statements. According to the company, however, the information on the website may not represent reality, but the reality that the company wants to show. So it is essential to adopt a critical approach to what the company says about itself, without !15

considering all the unnecessary data that tell about forward-looking results, but analyzing only facts, balance sheet items and what the company has actually achieved. If you find additional sources other than the company's web site to help you in this critical work, fine, but be careful to make a selection of what is really relevant for your purpose, which is to figure out whether it is worth or not to invest in it.

However, our main source of information is the financial statements of the company and it is on them that we are going to build our investment system.

To show an example of how to find relevant information, let us take a look at the UPS website in figure 2 (you can find the address starting from any search engine), but you can try on any other website of a listed company.

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Figure 2 - An example of a listed company’s website: United Parcel Services (UPS)

The first label to which you have to watch is the "Investor Relations" one, since it is the main source of all relevant financial information about the company. A world of documentation will appear at your eyes as showed in figure 3. !16

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Figure 3 – The Investor Relations page of United Parcel Services website

We suggest you to immediately select the "Financials" link or the "SEC filings" (SEC documents), or the "Annual Reports" link. Relevant information is often repeated between the different sections, and the best access to documents depends on the preferences of the individual investor. If available, and for American companies are, we personally prefer the SEC (U.S. Securities and Exchange Commission) documents, because these are all structured in the same way and it is likely that you will find the relevant information in a more rapid way. The annual financial reports, instead, are often very large, and the relevant information is often hidden, especially when the results are not so good!

The key items to arrive at are those of the financial statements, all the words around can be overlooked. If you follow the link to the SEC documents from the UPS website, you come to a page of the UPS web site which contains all the SEC documents of the past for the company, categorized per type: All forms, Annual filings, Quarterly filings and so on (figure 4).

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Figure 4 – Web page showing all SEC filings for UPS

The final step will be to follow the link highlighted as “10-K�. Each SEC filing has a code representing its type. The most important type is certainly the 10-K one because it represents the annual reports which are the main documents on which we build our investment system. Rarely we have to access quarterly filings (10-Q) or placements documents (S-1) which are those presented in the period in which the company makes its debut on the stock market.

Sometimes, for non-US companies listed in American markets, for example the Canadian ones, instead of 10-K filings you will find a different but similar form which is the 20-F one.

As you have seen we had to refer to the U.S. markets, which certainly represent attractive investment opportunities. With a purely national market horizon, investment opportunities are drastically reduced. In general, you must have an open view to the international market, as expanding the range is easier to find the best bargains. Surely it must be said that in the United States, after the Enron and WorldCom scandals of 2001-2002, the SEC has played a key role in introducing greater transparency in the publication of the financial statements, together with the federal law of the Sarbanes-Oxley Act of 2002.

As a result we believe that to date the financial statements of listed companies in the United States are the most clear and transparent available in the world.

Relevant information is identified immediately, thanks to the use of an identical template suitable for all companies, which must strictly comply with !18

directives. In a few seconds you are able to extract key information thanks to the use of the tables of the last 5 years. All this we believe has contributed even more to make markets in the United States the world's most important and certainly the point of reference for the present text.

For those companies not listed at American markets, you have to follow the direct link to the annual reports. In figure 5 the investor relations web site of one of the most important Swiss companies is shown: Swisscom. On the left you can see the tree of the investor resources; to access the financial reports you have to navigate to the “Results and reports” link and then to “Financing in detail”. As you can see you find all the annual and quarterly reports per each financial year starting from the most recent one.

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Figure 5 – Web page showing all Swisscom’s financial reports of the last years.

Another very useful section is the "Key Figures" one. Generally it is a synthesis of all the relevant data of the previous 5 or 10 years, and usually these are the only data that we need to extract from the millions of words scattered in current accounts. In the Swisscom website, the "Key Figures" section is shown in Figure 6.

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Figure 6 – Swisscom’s Key Figures

As you can see, there is a summary of the relevant data from the previous 5 years, where you can extract the figures that you need, without having to open all the previous five annual reports. So with a single click of mouse you are able to investigate the data from 5 different annual reports. This is another step in allowing you to reduce the amount of information to be analyzed.

In any case you do not have to buy financial information services, all you need is public and free, and allows you to build an opinion on the company by yourself.

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Building of our investment system

When we talk about financial accounts, we refer to two main documents: the income statement (or statement of earnings, or profit and loss account) and the balance sheet.

The income statement gives us the knowledge about what the company has achieved in the last period of time which, depending on the time horizon, can be annual, half-yearly or quarterly. In simple terms, starting from sales (turnover) that the company has made during the period, expenses, interest paid and taxes are deducted, to arrive at the "prince" figure, which is the net income (or net earnings). It represents what the company has earned after the ordinary and extraordinary management of operations and can be a positive or negative number. If positive, the same managers can decide how to use it, if still reinvest it in the company or if turn it back to shareholders as dividends.

We could outline a simplified income statement with the following items:

Figure of the Income Statement (Profit and Loss Account) Sales - Raw materials costs - Personnel costs

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= Gross Operating Margin - Amortizations = Net Operating Margin -/+ Financial income or expenses = Earnings Before Interest and Taxes (EBIT) - Interests = Ordinary Profits -/+ Extraordinary income or expenses = Earnings Before Taxes (EBT) - Taxes = Net Earnings (Net Income)

In Figure 7 we have included an excerpt from the income statement of one of the most important companies in the world: Berkshire Hathaway, madefamous by its tycoon, Warren Buffett. As you can see, the document compares data from different years, trying to give the opportunity to understand how the company is evolving. We have tried to highlight a mapping with the income statement items identified above.

You can analyze each item, depending on the level of detail you want to achieve; in any case what is most interesting to the investor are the figures, the last 4 lines in bold in particular. Net income corresponds to "Net earnings" and is shown in millions of dollars.

It is time to immediately justify our definition of net income, which is "the prince figure of the financial statements." Why is it considered the prince figure in relation to our stocks in order to find the most convenient in which to invest?

First of all, it represents the information if the company is producing results or not. If net income is positive it means that the company is able to finance its activities without requiring further loan from the banks, it is able to pay dividends and therefore guarantee a return for the investor. If it is negative, the company is unable to pay dividends, it must borrow from the banks to pay interests to the banks in the future and so on. A negative net income leads to a !22

vicious cycle that, if not stopped immediately, may even undermine the very existence of the company, at a time when banks are no longer willing to lend more money, and the company no longer has liquidity. In the event that the net profit is positive, as in the case of Berkshire, we must determine its amount, or find a measure of the profit of the company compared to its size.

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Sales

Costs EBIT

Taxes

Net Income

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Figure 7 - Income Statement of Berkshire Hathaway

Namely, one thing is a profit of 10 million â‚Ź for a multinational company, one thing is the same net income for a local company of 20 employees. In the first case it is a ridiculous net income, because the size of the company is worldwide and therefore one would expect numbers in the order of billions â‚Ź, !24

while in the second case it is a net profit of respect, since if the company has only two owners, these would share a portion of â‚Ź 5 million each!

A slightly positive net income may mean that the company is able to finance its activities, but that it is not able to provide an adequate return to investors, or to make investments to innovate and provide a satisfactory level of profits for the years to come because it is likely that it will not be able to renew itself and be in line with competitors.

When net income is significantly positive, the company is able to reinvest in its infrastructure and is able to pay dividends to investors. In general terms, the percentage of net income that the company uses to one or the other is 50% -50%, i.e. 50% of the net profit is reinvested in the company and the remaining 50% (the so-called Payout ratio) is used to satisfy the shareholders in the immediate in the form of dividend payment.

Let us try now to lead the final step towards the understanding of how the stock price is affected by all the above. To do this we need to introduce another simple concept, which is the amount of net income that can be attributed to a single financial share: we are talking about the '"earnings per share" (EPS) . It is obtained simply by dividing the net income that the company has produced in the last year by the number of shares outstanding in the financial markets included those held by "institutional" investors and not exchanged in the stock markets (i.e. those who own more than 2% of the total shares and who are entitled to vote at shareholders' meetings). For example, in the case of Berkshire Hathaway, EPS is shown in its income statement and corresponds to "Net earnings per share attributable to Berkshire Hathaway shareholders" (You may have noticed that for international companies financial statements are drawn up in English, then you should at least become familiar with the most important English business terms).

EPS is a key tool to find a relationship between the stock price and net income, as we are now to prove.

In fact, if 50% of net income is paid out as a dividend, this means that if the stock price at the time of purchase is P and if the EPS are the earnings per share, the return on our investment (ROI , return on investment) at the end of the year is: ROI = (½ EPS)/P In fact we paid P our stock and we are getting a return of ½ (i.e. 50%) EPS. To obtain the relationship between P and EPS, that is, as the stock price changes based on the net profit per share of the company, we need to replace !25

the return (ROI) with that of alternative fixed-rate financial instruments. The yield of stocks must be comparable to that of alternative fixed rate products, otherwise everyone would invest in stocks if they were more affordable or otherwise all would invest in fixed rate. For example, in our days you are lucky if you can find a proposed investment by your bank - i.e. bonds, government bonds or other - with a return of more than 3% gross. We need the gross figure, because also dividends are taxable and so 50% EPS of dividends must be considered as gross.

Therefore, by replacing the 3% to ROI, we obtain: 0.03 = (½ EPS)/P 0.03*2 = 0.06 = EPS/P P = EPS/0.06 = 16.6 * EPS So we can obtain the price of a share by multiplying the net income per share per 16.6, for average returns of alternative fixed instruments at 3% per year.

This already looks like a great result! This shows that the price of a share is not a random number, but is closely related to a figure of financial accounts and therefore closely linked to economic factors. And we begin to understand that price fluctuations are dependent on changes in net income or related predictions about how it can be quantified in the future, given that net income is not reported every day, but only every three months during the quarterly reports, semi-annual reports or annual reports and therefore the daily fluctuation of the price cannot be tied to a given account on a daily basis, but only at quarterly intervals. So the operators of financial markets forecast each day how many will be the net profits of a company, analyzing forecasts or anticipations by the management, but are forced every three months to match their predictions with the real data of net income present in the quarterly report, which at this point are no longer forecasts, but the actual data that need to adjust the price.

But let us continue to analyze our formula to best refine the relationship between price and earnings and assume for the moment that this period of low interest rates will end into the future, and let us suppose that your bank may offer you an investment of a 5% gross annual return. In this case, our formula becomes:

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0.05 = (½ EPS)/P 0.1 = EPS/P P = EPS/0.1 = 10 * EPS So in periods of high interest rates, you should record a general decrease in the value of stocks in relation to net earnings of companies, and for a stock to maintain the same price in periods of high interest rates the underlying company must register growing profits, what usually happens in cases of high interest rates, which generally indicate an expansion of the economy with growing profits. This also justify our initial statement about the particular convenience of stocks in time of low interest rates by alternative investments.

Our interpretation thus provides the result that the stock price should move in a range from 10 times to 17 times its earnings per share, depending on the interest rates available from alternative investments at fixed rates at 3% or 5% gross.

As evident, a further explanation of a price increase for low market interest rates is that if alternative investments do not provide a better return than stocks, then the majority of investors will buy stocks and thus raise the price up to the point where the return offered by the stocks is similar to that offered by alternative investments. In fact, when the stock price increases, the return from dividends that the investor records by the stock taken at this higher price is lower, attaining to that of alternative instruments such as fixed-rate bonds or government bonds.

Naming as “i” the current interest rate for fixed-income investments, our formula can be written in general in the following way: P = ½ * (EPS/i)

i.e. P/EPS = 1/(2*i)

The following table summarizes what the “right” P/E (i.e. P/EPS) ratios should be depending on the current interest rates for alternative fixed-income instruments, applying the formula above:

Interest Rate

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Right P/E

0,50%

100,00

1,00%

50,00

1,50%

33,33

2,00%

25,00

2,50%

20,00

3,00%

16,67

3,50%

14,29

4,00%

12,50

4,50%

11,11

5,00%

10,00

It must be said, moreover, in addition to our previous result, that the way we calculated the share price according to its earnings per share has been fairly conservative, because the managers of the firm may decide to allocate 100% of the net profits to dividends, and in general terms, however, the value of a company shall be determined on the full value of the profits, because this is all the surplus that the company was able to generate. According to this different hypothesis, our calculation would become at a fixed interest rate of 3% gross: 0.03 = EPS/P P = EPS/0.03 = 33.3 * EPS and, in the case of interest rates of fixed investment alternative at 5%: 0.05 = EPS/P P = EPS/0.05 = 20 * EPS Under this different point of view, the stock price should move between 20 and 33 times the earnings per share of the company. !28

The general formula would become: P = EPS/i

i.e. P/EPS = 1/i

The table above about the right P/E ratios depending on the different interest rates of fixed-income investments would become the following:

Interest Rate

Right P/E

0,50%

200,00

1,00%

100,00

1,50%

66,67

2,00%

50,00

2,50%

40,00

3,00%

33,33

3,50%

28,57

4,00%

25,00

4,50%

22,22

5,00%

20,00

Then basing ourselves on an empirical measure, we are quite confident that assuming a "right" price of the stock of a company like 20 times its net earnings per share, is a solid way to consider what the price of one share "should" be. And in fact, looking for empirical confirmation of this result, we find indeed that the most frequent value for the Price/Earnings (P/E) ratio that is registered among the most important and stable companies is around 20. But we will investigate this in more detail in the remainder of the book.

With this simple but crucial result in our hands, we are already in a position of big advantage over the majority of investors who buy stocks every day without knowing what they are buying.

But let us try to make further steps ahead. !29

Having identified a stock to be studied, with the method described above we can determine what the right stock price should be and compare this "ideal" and “right” price with that offered by the market. If the current stock price is considerably below our calculation (for example, a stock that is trading at € 5 while our calculation tells us that the stock should be trading at € 15), this stock could be a good opportunity to get a return in the future.

In fact, every day we can find many examples of undervalued or overvalued companies, because very often stock prices behave quite irrationally and do not reflect the real value of the company. For example it is enough for a company to submit a quarterly net income far below expectations to record a consequent reduction in the price of its stock, or otherwise just that a company submits a quarterly far above expectations to record a significant increase in the stock price related. Thanks to this, the '"Intelligent Investor" of Graham memory has an important advantage over other investors, only because he or she is able to find by himself or herself the right price of one stock and does not need to follow the crowd.

As mentioned a few paragraphs ago, the P/E ratio is not random and if we were able to calculate all the P/Es of all the companies in the world and putting on a chart the number of stocks to record a certain P/E range (for example from 10 to 15, from 15 to 20, etc. ..), we would get a kind of Gaussian distribution, that is, as the one shown in Figure 8.

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Figure 8 - Distributions with all the P/Es of the stocks under observation

The chart would indicate that most of the stocks is located in the range between 5 and 40 P/E, i.e. they are neither overestimated nor underestimated, !30

but priced in a "right" way. There is a smaller part of stocks with a P/E less than 5 (the undervalued) and another part with a P/E ratio greater than 40 (the overvalued). The “right� P/E shown in the tables above should apply to ALL the stocks available in the stock markets, while in reality this does not clearly happen, but some have higher P/Es than others.

In the chart those companies with negative earnings would not be included.

Among the companies in the chart, those with a large P/E should be avoided while diligently sought those with the smallest possible P/E. In our experience, we often come across companies that are traded at a P/E of 1, which is ridiculous, it means that if the company from one day to another comes back to give dividends for a 50% of the profits, it would immediately return the 50% of the investment!

The chart above also allows us to make us sure, then, that our theory of the P/E is not illogical. If it were so you would find with the same probability stocks with a P/E of 1 or 100 or 1000, whereas the reality tells us clearly that it is not so, but stocks with a P/E of less than 5 or more than 40 are a rarity on the total. Currently, for example, among the about 700 stocks in the world that we keep currently under observation, there are 13 stocks with a P/E less than 5 and about 120 with a P/E above 50. The remaining 600 companies navigate in the [5, 50] P/E range.

The distribution of the P/E reflects much the global macroeconomic environment; in periods of crisis distributions shifted to lower values of P/E will be recorded as the general opinion on the economy and pessimistic forecasts lead to estimate restrictively future profits of companies. In contrast, in periods of euphoria the majority of investors will be brought to optimistically predict the evolution of the profits of a company and consequently its share price. So this says us that a stock price include in itself a part related to achieved results and a part related to future forecasts on how future earnings of a company will evolve.

Despite this great achievement in terms of understanding the causes of price movements, not everything is easy, unfortunately. We can assume that sooner or later there will be an alignment of the share price to the "right" price, but the big problem is that we are not able to predict if and when this alignment will happen. In fact, we can decide that the price is incomprehensible, but in the end it is the market that decides and the individual investor has no power to influence it. The risk is to wait for years before the market recognizes that the price has to be corrected. Or it may happen in a few months, or never happen because the company ends up in bankruptcy, it is impossible to !31

predict. In any case, we made our reasoning with the power of our system and we do not invest in something we do not know and for which we have no way of knowing whether it is worth or not to invest in it.

Having said this, we must now understand what kind of earnings to consider, and which of them cause fluctuations in market prices of stocks.

If you have, as you should have, a long-term perspective, you cannot focus your efforts on the net income of a single quarter, because this can completely change from quarter to quarter. As mentioned above, the risk is to invest in a company just because it has shown a quarter of attracting earnings, realizing in the following that the previous results were not repeatable, so that we are forced to sell the stock because the conditions that led us to buy it are no longer valid.

To avoid this great drawback, we suggest you to consider only the annual financial accounts, they are more than enough to understand the real value of a company: this method also reduces the amount of your work as an analyst, as it greatly reduces the amount of data to collect and study. In addition, we suggest you to consider more than one year, because a company can show a very good income for a year followed by a less good one, leading us in bad investments. So we strongly advise you to consider the net profits of the last 10 years and make an average of them: this can really be the determining factor to avoid mistakes, because if you buy a company underestimated if compared to the average of the net profits it has registered in the last 10 years, there are chances you are making a great investment because it could mean that the company is currently undervalued, but it has proven in the past over the long term to be able to generate results which are currently undervalued by the market. But this is always in general terms, to be checked in each case. In fact, a company may also have generated in the past high levels of profits, to record a decline in the years following, experiencing structural decreasing of the sector of its business, which forced it to reduce staff and business volume and to aim for a mere survival. It is clear that in such a situation a level of profits in line with the best years is unimaginable and it is therefore likely that a return to the price of the good times will never happen. Or on the contrary, there are companies that have registered in the last years windfall profits than in the past, because they entered into a young business, they have created a monopoly or other, and then taking the average earnings of the last 10 years, can lead us to consider it overvalued, while it will be able to provide in the coming years increasing profits (take Apple for example, which is one of the most overvalued company in the world on average earnings in 10 years but which could be dangerous if suddenly the !32

attractiveness of its products should fall). So every company should be examined on its own.

Moreover, very importantly, by considering the 10-year average earnings, we are able to attribute a P/E ratio also to those companies that in the last year have registered negative earnings, otherwise we would obtain a negative P/E which would have no sense. So, if the company has a story of repeated negative earnings and so has a negative 10-year average earnings we can throw it away and not consider it for the next couple of years; but if the company has presented a negative net income just in the present year, while in the past years it had been always profitable, we can consider the 10-year average and attribute a P/E to it based on this average. These are the cases that usually confuse investors who base themselves only on the earnings of the last year, and who are not able in these cases to understand if the stock is worth again or not and how much it is worth.

In addition, with the 10-year average earnings we can also determine the level of reliability of a company, because while it may be relatively easy for a management "adjust" the financial data for a single year, by postponing the negative figures to the following years, this exercise is not viable for 10 years in a row and then using the 10-year average we can unmask those attempts made by some companies to present financial data "embellished" with respect to the real and actual ones.

As a general example, let us analyze the income statement of Berkshire Hathaway, certainly one of the most reliable companies in the world, in figure 7 at the beginning of the chapter.

It shows an increase in net income (this is the item "Net earnings attributable to Berkshire Hathaway") in the last three years: from $ 12.9 billion in 2010 to $ 14.8 billion in 2012, having resisted quite well to the financial crisis during the last years and demonstrating a return to normal levels of earnings in comparison to those which was able to generate before the crisis of 2008.

From the income statement you can see that net earnings per share (item "Net earnings per share attributable to Berkshire Hathaway shareholders") are $ 8,977 per share. These days, a Berkshire Hathaway stock is traded $ 167,780, and this means a P/E (price on earnings, price divided by earnings) of 18.69.

If you consider that we set at 20 times the right price that a stock should sell compared with its profits, the right value of Berkshire, considering only last year profits, should be slightly more than the current one.

But this way of determining the price of a share can be risky, because considering only one year can lead to the risk that the next year will be less !33

productive than the current one, leading to a drop in the share price in the future.

To prevent this, we have to consider the amount of profits that Berkshire recorded in the last 10 years. And these are (in million $): 2012: 14,824 $ i.e. 14,824,000,000 $ 2011: 10,254 $ 2010: 12,967 $ 2009: 8,055 $ 2008: 4,994 $ 2007: 13,213 $ 2006: 11,015 $ 2005: 8,528 $ 2004: 7,308 $ 2003: 8,151 $ The 10-year average is 9,418 million dollars. If we divide this number by the number of shares outstanding (item “Average common shares outstanding”) that are 1,631,294, we get an earnings per share of $ 5,773. Multiplying this value by 20 times we get an ideal price of $ 115,466, which is well below the current market price of $ 167,780.

So, considering last year Berkshire profits, it seems having a fair price, while considering the 10-year average it is not an attractive investment, at least for the potential it has to return an immediate gain from the realignment of the price with a fairer value.

But the 10-year average is not always too conservative. And this is clear considering the Ing Groep case. The list of Ing’s net profits in the last 10 years is as follows (in € million): 2012: 2011: 2010: 2009: 2008: 2007: 2006: 2005: 2004: 2003:

3,894 € 5,766 € 2,810 € -1,006 € -868 € 9,238 € 9,241 € 7,692 € 7,210 € 5,755 € !34

The 10-year earnings average is 5,055 million €, out of a total shares outstanding of 3.8 billion, and net income per share of € 1.33, which multiplied by 20 is a fair price of € 26.6. The Ing stock is currently selling at € 7, so a potential return of 300%! If only from an array of market price to a more real one. It may be clearer putting the Ing earnings in the last 10 years in a chart, as in figure 9.

!

Figure 9 – Last 10 year earnings for Ing Groep

From the chart above you can notice that the price drop was due to the fall of net earnings in 2008, 2009 and 2010. In 2011 and 2012 the company has come back to earnings which are more or less the same of the 10-year average of earnings, but despite this the P/E is yet very low, as it should be at least 4 times the current price. This gives us the important information that after a price has dropped to very low P/Es, it needs more time than expected to realign to a normal price.

You may wonder why the Ing stock price has dropped so much. There is an answer to this, which also says that the net income does not say everything about a stock. Ing found itself in a situation of illiquidity, after the 2008 crisis began, and it was rescued by the Dutch government through a € 10 billion loan. So the stock price has dropped for fear of bankruptcy by investors (if a company goes bankrupt, its shares have a value close to zero ...). Only after it was rescued by the Dutch state the price was up again, but Ing has not been able to pay dividends also because it is in obligation to repay the loan and interests. However Ing has started again to produce substantial profits and the fact that it would return to pay dividends is not so far from reality. Either way !35

the Ing case is one of those for which the power of the concept of the 10year average profits may be consistently demonstrated.

So an investor should be careful when a stock has depreciated too much...

When a stock begins to trade at a very low P/E, this could be due to a critical liquidity situation which can lead to insolvency and then bankruptcy, making junk its stock. So a general rule should be not to ever invest important parts of our capital in companies with a too low P/E, because there could be nasty surprises.

In the opposite case, however, should the company recover and overcome a critical period, the returns on this type of stocks would be to triple digits in a short time. To stay up to Ing case, look at what has happened since March 2, 2009 to October 12, 2009, which is approximately 220 days (Figure 10).

The price is risen from € 3.03 to € 18.36, i.e. a 506% yield in 220 days, then 840% on an annual basis. Ing has grown from a P/E of 2 to a P/E of 10. € 1000 would have become € 5000. But it does not always go so well. Listed companies often fail, especially if small. But the latter aspect will be discussed in the chapter about the size of companies.

Another stock that has directly involved us is Genworth Financials. Even this stock was depreciated in such a way that the P/E was less than 1. Let us see what has happened from November 17, 2008 to April 19, 2010 (Figure 11).

The stock went in about 500 days from $ 0.99 to $ 18.10, that is a return of 1730%, or 1250% on an annual basis! € 1000 would have become € 17.300!

!36

Figure 10 - Evolution of ING Groep’stock price from March 2, 2009 to October 12, 2009 Figure 11 - Evolution of Genworth Financials’ stock price from November 17, 2008

to April 19, 2010

In general, from our experience, the stocks at a lower P/E are stocks fallen "out of fashion", i.e. those that are snubbed by the market because they do not return dividends or because they are considered operating in business with little future (e.g. the steelmakers ArcelorMittal). In contrast, those with a high P/E are stocks deemed the most trendy of the moment because of their business in attractive sectors with strong prospects (e.g. Apple or Google); to check if they actually will maintain these expectations. When we say of wanting to stand out from the mass, we mean just that; we will see that according to our investment system, Apple and Google stocks are not attractive (not to mention LinkedIn trading at 3500 P/E or Facebook and Amazon trading at 250 P/E), instead ArcelorMittal (3 P/E) on the contrary could be very interesting in the future as we shall see.

When the stock price of a company falls at the level to bring the P/E near or under 1, it is quite sure that the company is tackling a survival challenge: i.e. a period of time in which the company is struggling to come back to positive earnings after quarters of deficit, in which it fell because of wrong choices !37

made in the past and that it must correct as soon as possible. If the management will not be able to recover the situation, the company will end in bankruptcy and the stock will be garbage; on the contrary if the management will be able to recover the errors of the past, the price will return to normal values and those who have bought the stocks at very low prices will register gains above the norm. This is the main reason for which we say you to not invest important parts of your money in this kind of stocks but just small percentages (5% of the capital for example) and only after having some clues which says us that there are the conditions for a recover. The Nokia case we think is perfect to show this phenomenon. The following analysis refers to the period before the acquisition of Nokia by Microsoft announced on September 1, 2013. After that date, the phones business line of Nokia was acquired by Microsoft for about $ 7 billion, which makes the subsequent analysis no longer valid on the Nokia stock, which has since been deprived of its main line of business.

For decades Nokia has been the main seller of cellular phones and one of the most strong brands in the world demonstrating a strong profitability. In the last years it made the great error to underestimate the smartphone market and it did not sufficiently invest in that field. Suddenly the sales of traditional cell phones dropped and it was surprised and suddenly it found itself at the margins of the market in which it had been the main competitor for years. Let see the impacts of these events on the earnings Nokia has registered in the last 10 years (figure 12). In 2011 it presented the first negative net income and the same trend continued for the 2012, even with more important numbers.

Nokia share price dropped consequently, as shown in figure 13, till reaching the minimum of $ 1.71 on April 2nd 2012, date in which its P/E calculated on the 10-year average earnings reached a minimum of 1.5.

!38

!

Figure 12 – Last 10 year earnings for Nokia

!

Figure 13 – Evolution of Nokia stock price in the last 5 years

In that moment there were just 2 possibilities for Nokia: continue its decline and come to a quick bankruptcy or enter as soon as possible in the smartphones market to try a recover. A wise investor would have tried to make an analysis of the business situation of Nokia to predict if a recover would have been possible. !39

At the moment (May 2013) it seems that Nokia could be able to find a recover, as demonstrated by the set of smartphones proposed to the market.

The Lumia series of smartphones seems to have reached a very good appeal among the public, in particular the 920 model (figure 14), which is sold-out in the majority of stores in the world, exactly what is happening to Apple’s products.

!

Figure 14 – The Nokia Lumia 920, the current Nokia flagship product.

All this changed scenario has been reflected in the share price which has skyrocketed to a price of $ 4.7, leading to a less strange P/E of 4. Having bought at $ 1.7, a wise investor would have registered a gain of near 150% in 6 months! At the current conditions it really seems that Nokia has managed to exit from the crisis it had fallen in and an investor would have had no reasons to think to sell the stock till when it would have fully recovered to a P/E of more than 20 and if Nokia continues to innovate its products it could not have been reasons to sell for years to come. To obtain the highest return an investor has to keep the stock as long as possible, to avoid to reduce gains paying intermediate taxes on the gains themselves. Remember, an investor is not a speculator!

!40

After the acquisition of Nokia by Microsoft all the convenience of the Nokia stock was acquired by Microsoft, which paid much less than what Nokia could potentially be worth.

In cases similar to Nokia’s the brand strength is fundamental. Thanks to decades of sales in cellular phones, Nokia has built a wide base of faithful customers who are really glad to come back to their preferred phone brand and this seems is just what is happening in these days. The greatest bargains are in general made investing in these strong brands undervalued companies which manage to recover from a negative phase.

That said, the last point to consider and even more important is the following: after the price of a stock has realigned itself to a "right" price as calculated by our investment system, what drives the price fluctuations of the stock itself ?

Apart from psychological reasons, as mentioned above, we can say that a change in the share price is closely related to a change in the amount of net income recorded, but the important point to be fixed in our mind is that financial markets always move months before financial results are written to an annual account. For example, Ing’s stock price collapsed in 2008, while the latest annual report still showed a net profit of € 14 billion! But one year after the start of the crisis, Ing showed a loss of € 1 billion and if the Dutch state had failed to provide help, Ing would have gone bankrupt and the next annual account would have never been published! For the stocks of banks, in fact, the investor should consider that the amount of money handled far exceed the amount of liquidity in the balance sheet and, therefore, this is an additional complication in the evaluation of the goodness of the investment. For example, in the case of Ing, cash is of € 26 billion, while the total value of the sources of the balance sheet (liabilities) and that the bank is to administer and manage is 1250 billion €, which come from money customers keep on bank accounts or from amounts administered. Of course, a bank does not maintain as cash all the sources of the balance sheet because otherwise it would not be able to get any earnings but only expenses, because it would be not investing the money of the customers and thus when a very large mass of customers asks for their money back at the same time, the bank may be in a situation of illiquidity. In the Ing case, the moment in which in a few days customers should ask back a sum of more than € 26 billion of liquidity available, the bank would be in a dangerous situation because it would exhaust all its bearing current liquidity. This is one of the reasons why the control bodies have introduced over the years minimum capital requirements that banks must !41

abide by (the various capital Tiers), but we think this topic is more for specialists.

So investing in stocks is a big challenge and even if it is approached with a good investment system in our hands, it is not sure we can get the return hoped. But under current conditions we can say that, considering our method, also Ing can really be a good investment for the future.

What can allow us to predict how the profits of a company will evolve (and therefore the price of its stock) can be to consider a figure (the equity) within another account document, the balance sheet, considered always in relation to the 10-year average net income.

While the income statement considers the period of one year (or 6 months or 3 months), listing what occurred in that period, the balance sheet provides a snapshot made about the company at a given time. It shows the sources of economic resources (liabilities) and how they are used (assets), that is, from whom the capital is provided and how it is used. For this reason, the balance sheet is also called the register of sources/uses. In Figure 15, we show as an example the balance sheet of Berkshire Hathaway.

We could outline a simplified balance sheet with the following items (we have put in bold the components of equity):

Assets

Liabilities

Cash

Initial Equity

Machinery

+ Issued shares premium on nominal value

Brand (Start/Goodwill)

+ Last year net profit

Raw materials

= Total Equity

Finished products

Issued bonds

Financial investments

Short-term bank loans Medium/Long-term bank loans

!42

As usual in our approach, we are primarily interested in those figures which can help us in terms of our future investment in the stock. For this purpose, the figure that interests us is the equity, i.e. the capital provided by shareholders which also includes profits held in the company, i.e. those not distributed as dividends. Significant changes in the amount of equity capital, occur during capital increases (increase in equity), shares buyback (reduction of equity) or, as mentioned, at the end of the financial year in relation to the portion of net income kept by the company and not distributed as dividends, and that is added (or subtracted in the case of losses incurred during the year) to the equity.

The equity allows us to calculate an important parameter which is the so-called ROE, Return on Shareholders' equity (Return on Equity), a measure of how the company is able to return on the capital employed. It is calculated by the following formula: ROE = 10-year average Earnings / Equity For example in the case of Berkshire, using the 10-year average of Earnings (net gains), the ROE will be: B.H. ROE = 9,417 billion $ /187,647 billion $ = 5.02 % The higher the ROE, the higher the return that the company should be able to offer on the investment of its stocks. Since buying shares of a company means investing in the capital of the company, the higher the ROE, the higher the return on the stock we can expect in the long term. Why in the long term?

Because the equity is also made of earnings not distributed as dividends, then earnings are increasing the equity, then the denominator of the ROE and for the ROE to remain constant the profits (at the numerator) and therefore the stock price need to increase as a consequence. It is a virtuous circle that leads to an increase year by year of company turnover which is finally transformed into profits. This is the fundamental result which builds our entire system: to invest in stocks over the long term the investor must necessarily choose the stocks of companies having the highest possible values of ROE. So we can say that while earnings per share in the form of P/E shows us the extent of a possible immediate alignment of the stock price to a “right� value, !43

the ROE gives us a measure of the return that we can expect in the long run by the company: then respectively a perspective in the short term that may or may not occur immediately (because the market price may take some time to line up) in the first case and a long-term perspective that gives us a measure of how a company could return back each year for the years to come in the second case. It is not so difficult to find companies that show a return on equity of 20% or even 30% per year or more, but we will see this more in later chapters. An investor managing huge amounts of money should choose mainly high-ROE stocks, on which he has not to expect extraordinary gains such as those with very low P/Es, but more stable returns avoiding bad surprises in share prices drops. On the contrary an investor with few capital at disposal may be more oriented to low P/E stocks to search for extraordinary results.

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Figure 15 – Balance sheet of Berkshire Hathaway

You may argue why we have not considered the 10-year average of equity in the calculation of ROE, but just the last value of equity. This because in the last value of equity the history of earnings is already included, because equity is made of the cumulative sum of retained earnings of the previous years. So !45

in the last value of equity we have already considered the history of earnings the company has registered.

Other measures that an analyst could consider, but which are best suited to a specialist in the field, is the amount of debt that the company must take and the amount of cash it owns.

But if a company has too much debt it would not be able to guarantee acceptable profits, because it should pay too much interest on borrowed money, so it is impossible for a company to record for 10 years high debt and satisfactory profits, because in the long term the effect of the interests paid necessarily affect the 10-year average net profit. Here then, the soundness of the choice of the 10-year average earnings, a key concept of this work, is further demonstrated.

Regarding liquidity, a high ROE stock generally mean that the company is regularly paying dividends, which indicates that it has at least the liquidity to pay them, consequently not increasing equity too much. In fact, if a company pays dividends, the portion of income which goes to increase equity is reduced and therefore the equity does not grow too much. At each financial year end the only component of net income to be added to the previous equity to get the new equity is earnings not paid as dividends and then reinvested in the company to improve modernization of the company itself.

Maintaining a not excessive equity, ROE therefore remains high over the years and we as investors have the prospect to expect for the coming years a regular payment of dividends. Companies paying dividends regularly since decades show generally low amounts of equity and high values of ROE, opposed to those making great earnings which, not distributing earnings, register very high values of equity and so low values of ROE (as Berkshire Hathaway and Apple for example). This further justify the choice by a huge-capital investor to invest mainly on high-ROE stocks, obtaining just only with dividends satisfactory results. An investor managing few capital would gain small amounts from dividends, so he or she has to try more than normal returns buying low P/E stocks.

Another aspect that can say that a high ROE means high liquidity is that, if a company has a low equity (and so a high ROE), this can be due to a huge repurchase of shares made in the past, which means that the company has demonstrated to own the sufficient liquidity to repurchase its own shares at market values, which often are quite higher than those at which they were sold initially to the stock markets. For this reason it is possible for some companies

!46

to register negative values of equity, just because they have repurchased great amount of own shares at higher prices than the initial public offering (IPO).

So for the average investor considering the ROE and P/E is already a good starting point, because if a company shows a high ROE, it means that it is generating quite satisfactory earnings and that it is not diluting the capital entering further shares on the market (equity capital is not excessive). The more a company dilutes the capital with constant capital increases, the less previous investors will benefit from the profits, because the investors base to be "rewarded" widens and ROE decreases, increasing the equity in the denominator.

We emphasize, finally, that a high ROE also indicates that the company can produce earnings with little capital requirements, i.e. that it is operating in a business that does not require large investments, stable, which does not require renovations of infrastructure nor continual adjustments to stay abreast of the times. In general, the best companies in which to invest are those for which capital investments made are not depleted, for example, the equipment has a life of much greater span than the amortization period and does not require constant replacement. So the company is buying machinery and building infrastructures whose expenses are included in the income statement as an expense during the period of depreciation - for example, an investment of â‚Ź 1 million is included as an expense in the income statement for 4 years in a row as a cost of â‚Ź 250,000 - but it is using those machines and infrastructure for a much longer period than 4 years, so that this cost is no longer present in the income statement as an expense because it had already been discounted and the level of profits will not be affected any more by those costs that go to erode the initial turnover and it does not have to purchase new machinery because the old continues to be valid and working because the business does not require more and more advanced machines to keep pace with the changing times. Of course, this hypothesis is plausible only for some economic sectors, certainly it does not apply to companies operating in technology, but you can certainly apply it to tobacco companies. A machine that produced cigarettes 10 years ago will probably still be good to continue to produce cigarettes, albeit perhaps with different compositions of the content in the mix of tobacco.

Companies operating in high-technology sectors as Apple can register big profits, but they must invest heavily in research in new technologies and materials to maintain their competitive edge and thus they will be forced to return most of the profits to the company in the form of investments to keep pace with the changing times. For a company operating in a high technology sector there is no other choice, if not the end in a short time (just think of the !47

dramatic decline suffered by Nokia in recent years for example, as discussed before).

A high ROE therefore tells us that the company is making good profits (the numerator of the ratio of ROE) without requiring large capital (in the denominator of ROE). Of course, one could argue that a company could still make big investments without increasing the equity (i.e. without capital increases or withholding all earnings and not giving dividends) but wondering strong loans to banks, thereby increasing heavily its debt toward the banks. But doing so it would not be able to guarantee good profits for 10 years in a row because it would have to pay higher interest which always erode the operating profit before obtaining net income and then being able to maintain a stable equity but not to have satisfactory profits and thus the ROE would still be low (low denominator but also low numerator).

It is important to say that the analysis of ROE cannot be applied to companies in the banking industries. This because banks are forced by banking regulators to keep a minimum level of equity into the balance sheet as protection to the risks they face by lending money. So for a bank you will hardly find high values of ROE, because they never show low values of equity. So with our system you will hardly find bank stocks as good investment opportunities.

If we look at the ROE distribution for the stocks we have under check, we can notice something very similar to what happens for the P/E distribution, as shown in Figure 16.

!

Figure 16 - Chart of ROE distribution of the stocks under observation. (www.theawareinvestor.com) !48

We note that most of the stocks have a ROE less than 20% and that the greatest number of shares lies in the range between 5 and 10% of ROE. Investing in stocks with ROE greater than 20% means investing in the best long-term stocks. Should these stocks also record a not excessive P/E we have probably found the best stocks to buy.

At this point, if you understood as said in this chapter, you are more in a position of advantage over the majority of "do it yourself" investors who buy and sell every day in the financial markets. The rest of the book will only take a further refinement of the two fundamental concepts learned so far (the ROE and P/E theory) and will try to structure this knowledge and finish it in a robust and comprehensive investment system.

!49

!50

Considerations about Size

Do we need to consider the size of a company in choosing the best stocks?

The answer is YES. In general terms, large companies involve greater interests, when one of them goes bankrupt the echo throughout the world is very vast. Think of the Lehman Brothers case, the effects were devastating for all other companies around the world. On the contrary, how many small banks or firms have ended up in bankruptcy that no one came even aware of ? Probably dozens whose investors had no information about it. So bigger is better and, using a quote from Buffett: "I would rather own a small part of a large diamond that the entire part of a ring of jewelry."

A large company probably has a history of success behind it, with a business model of success and certain outlook, a small one must demonstrate that it is able to ensure a sustainable future with stable returns on investment in the future.

If a small listed company exchanges with a very low P/E, it is difficult to retrieve information about its liquidity position, and therefore it is not easy to decide whether to invest or not in it. Large companies with low P/E in general could represent a big bargain as Nokia, but after the Lehman Brothers case cannot be said with certainty that either ... Each case must be analyzed on its own, but the Lehman Brothers case will probably remain in history as an anomaly and an exception in the world economic system, and its treatment would require a separate chapter that is beyond the scope of this text. !51

However, investing in the shares of a company just because it has a great dimension is not wise if it has not demonstrated an adequate profitability in the past. Moreover the more a company increases its dimension, the more it has difficulties in guaranteeing a good return in the future, because it needs to enter new businesses after those in which it has invested in the past are already saturated.

It is a similar situation that occur for an investor in the stock markets: one thing is guaranteeing a return on 1 million $, another thing is guaranteeing the same return on 100 billion $ because it would mean investing not only on the best investing opportunities but begin to accept also “so-so� investments.

So, well considering dimensions, but not basing an investment decision just on that.

Another reason to prefer large-cap lies in the fact that small-cap companies are more likely to be purchased by other companies and therefore to make us lose our future profits. Typically shares at low P/E and therefore presumably small caps are coveted by potential buyers who know they can buy at an affordable price a company that could be worth much more. If the acquiring company is not a good investment, the shares of the acquired company would be incorporated in the shares of the acquiring company in which we would have never invested. In these cases, the investor should wait until the time of the definition of the purchase price - which will typically be higher than a "premium" than the current one - and wait for the alignment of the share price to the price of the acquisition, at which point she can sell the shares of the acquired company, provided that the stocks of the buyer company are not attractive. For example, if a company with a ROE of 50% and a P/E of 5 is bought by a company with a ROE of 7% and a P/E of 30, the investor should definitely engage in the sale of its shares of the company purchased after the price was in line with that established for the acquisition.

!52

About dividends

For what we have said so far, it should be clear that dividends in their current payment or in prospect, have the main influence on the price of a share. Rest assured that if a company pays dividends regularly, the price of its stock will be less prone to unpredictable changes when compared to that of another that does not pay dividends. Somehow the dividend "justifies" the stock price, because if a share returns â‚Ź 1 dividend per year it is unlikely that the stock price will fall below â‚Ź 10, otherwise it would return more than 10% on the investment by the return in the form of dividends alone, which would result in a race to purchase the stock, until the price rises to a level that brings the return on investment to more normal values.

If a stock pays dividends, generally it will not record very low values of P/E because investors will be attracted by the cash received from the regular payment of these. Conversely, if a stock trades at a very low P/E is likely to have stopped paying dividends and, therefore, the investors do not find a solid basis on which to determine the price. For a stock that does not pay dividends any price is allowed to minimum values as the price itself is no longer justified by a tangible return in terms of the payment of a dividend.

There are very few cases where companies that do not pay dividends assume very high values of P/E: among these there are Apple and Berkshire Hathaway but they have a history of success that serves as a protection to an excessive reduction of the price. However, according to our investment system, Apple and Berkshire Hathaway are not in our best investment opportunities. !53

The performance given by a stock by the return by dividends alone is named the dividend yield, obtained by dividing the amount of dividend per single share per the share price. Generally this number is not over 5% gross; rarely stocks offering dividend yields higher than 5% can be found and these stocks are generally the undervalued ones for which the underlying companies continue to pay dividends. If the P/E fall under 10 it is possible that the dividend yield rise to values also near 10% and above. In figure 17 we show the best dividend yields we have been able to find among the stocks we have under observation.

!

Figure 17 – Best dividend yield stocks

!54

While ROE and P/E try to predict which can be the best stocks in the future, the dividend yield gives the information about the current level of gains offered by companies, which can change in the years to come. The dividend yields shown in the figure are related to the dividends declared in the previous year, which could not be confirmed in the next one. HTC Corporation is offering an exceptional dividend yield of 14.34%, because the share price has dropped to a P/E of 9.86. With more normal prices the dividend yield would have been certainly high but near 7%. Though the exceptional dividend the share price has dropped a lot because for 2012 HTC has declared one fourth of the net income it declared in the previous year. So basing an investment system only on the amount of the dividend yields can be very dangerous, because it does not take into account forecasts for the year to come, but just what would be the gain at the current price should the company continue to pay the same dividends paid in the previous year.

It is very important to add that dividends are taxed according to the rules of taxation on capital gains, for example in Italy at the moment a tax of 12.5% applies. And it is even more important to note that to foreign stocks, for example the American ones, a double taxation is applied to European investors for example, by the foreign State and the Italian State, so that the final net return results greatly reduced. And this is just the case that applies to Philip Morris, Altria, and all other United States stocks and in general outside European boundaries.

This factor is what, sometimes rightly, sometimes taken as a pretext, is the cause which lead the managers of companies to decide not to pay dividends.

Paying dividends "would waste" a portion of the profits in the form of taxation and thus reduce the profitability of the company, which would not happen if the profits were reinstated in the company in the form of capital reserve therefore going to increase only equity. Gains reinstated in the company could be used to further enhance the business, make investments and, therefore, produce more profits in the future. What we have said is exactly the reason that Warren Buffett has historically provided about his decision not to pay dividends.

However, when this strategy is used to cover any waste of capital by the company then it becomes an excuse that does not last for long, however.

Therefore, the analysis of 10-year profits also protects us against this further inconvenience.

The decision to not distribute dividends is acceptable when the company is in a development phase in which it is extending its business in other sectors; for !55

example the decision by Google to not distribute any dividend can be accepted, because Google is entering in more and more markets year by year.

Google has begun with a web search engine, but now it has entered a number of different markets: it has devised a new operating system (Android) which is the most widely used on the smartphones in the world, it has entered the smartphones and tablets market, it has devised a pair of glasses able to put the screen of a computer directly on the eyes of the customer. In few words, it is deeply investing in research, in the same way as Apple did in the past years.

On the contrary, a company operating in a stable market has to pay dividends, because it is not able to reinvest all its earnings to expand its business. As soon as Apple has reached a stable position in the smartphones and tablets market, it decided to begin to pay dividends, even if with small amounts if compared with the hugeness of earnings it is able to generate. And this is causing a drop in its share price, both because investors do not see exceptional long term perspectives and because they do not receive an acceptable percentage of dividends on the shares owned.

If an investor holds a stock in the long run he or she will not have to worry much about the dates for the payment of dividends. However, if an investor intends to exit a stock but only after having received the dividends, he or she must take into account the following dates associated with the payment of a dividend: •

the date of declaration of the dividend (declaration date): the date on which the company says that it will pay dividends and when;

•

ex-date (ex-dividend date): date before which a new shareholder must purchase the stock to be entitled to the dividend. This because the register of shareholders of the company requires 2-3 days to be updated, so this date is used to determine who among the seller or the buyer is entitled to the dividend;

•

record date: the date by which you must have the stock in order to be entitled to the dividend;

•

payment date: the date on which the dividend is actually paid.

Therefore, to be entitled to the dividend the investor should sell the stock after the record date and still possess at least for the days that go from the exdividend date to record date.

It should be added that the frequency of dividend payments marginally affect the share price. In fact, the days before the record date of the dividend payment, there will be an increase in the stock price due to the arrival of !56

speculators who are interested in dividend, immediately after the record date of ownership there will be a decline in stock price due to the speculators who want to use cash to buy elsewhere and collect dividends on another stock. But it is not so easy to sell immediately after the record date because many have the same intention and need to sell at any price (the best) to get rid of the stock. The first that sell can benefit from this artifice (which we also call arbitrage), while the latter cannot practically get any gain considering the total of the dividend paid and the loss incurred in the sale and bank charges.

To reduce a little this drawback, some companies fractionate dividends in more infra-annual payments (e.g. every three months), so that the amount paid does not exceed 1% of the stock price and to reduce speculative attacks. In this way, the share price is stabilized and is less subject to speculative attacks.

But there are not so many companies that pay so many dividends such that they can divide them among more than one payment per year, among them Philip Morris, Altria, Lorillard and also Eni, just to mention a stock in the Italian market.

A final consequence of the payment of dividends is the general rise in prices which usually occurs in the months before spring. In fact, in the months between April and June, most of the companies pay annual dividends, which are closely related to the closure of the financial year. Typically a company declares the amount of dividends based on the amount of profits recorded at the end of the financial year. The financial statements are published in most of cases in the first months of the year and this implies the fact that dividends are paid in the months immediately after. So for those who want to start investing in stocks they should start buying the desired stocks in the autumn/ winter months to be prepared for the increase in prices finally leading to the payment of dividends. The worst choice instead is generally investing in the months from June to August, because they are the most distant months to the next dividend payment. This obviously does not apply to companies that fractionate their dividends in several tranches during the year, for example, 4 tranches of dividends every three months (for example Philip Morris, Altria, Lorillard, Moody's, GlaxoSmithKline, IBM, etc.). or two tranches of dividends every six months (for example Eni).

In addition, a further explanation of the post-dividend price drop could be due to the fact that many small investors decide to leave the stock exchange in the summer months, maybe to spend in their holidays the gains obtained, coming back in the markets in the month of September, for example. A similar phenomenon we believe occurs, albeit with less evident price declines, on Fridays, due to small investors who prefer to stay away from the stock !57

exchange during the weekend and maybe spend in their weekend the profits made during the week. In this way, negative events that may happen during the weekend would not have an impact on their wallets.

All this can be quite frustrating for an investor who instead remains in the stock exchange for very long periods, but in the long run in and out all the time from the stock exchange produces only drawbacks in terms of taxes on capital gains, bank charges, reduced dividend yield and higher purchase price and, finally, because whoever comes out today from the stock exchange sooner or later will most likely return to buying at less affordable prices than purchase’s.

On the contrary, as in the months of January, April, July and October companies submit quarterly reports, usually in these months there is a general increase in prices for those stocks that target or improve ("beat the estimates") the analysts' forecasts.

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A possible index to rank stocks

From what we have said in previous chapters, the factors that an investor must calculate and consider are the following, according to our order of importance: 1.

2.

3.

!59

ROE as a measure of long-term capacity of the company to ensure for the years to come an adequate return for our investment in stocks, according to the principle that buying a share is the same as entering in a portion of the capital of the company; ROE must be calculated on the 10-year average net profits. The larger part of your portfolio should be composed by high-ROE stocks; the return to expect on this kind of stocks is probably not exceptional but more stable during the years. the P/E (price divided by earnings) as a measure to understand how the stock is undervalued or overvalued now, so having a measure of the possibility of a realignment of the price to the "right" price. It is important of course also in this case that the earnings are calculated according to the 10-year average. The rule to follow is to not spend large parts of your capital on companies with very low P/E, because it means almost "bet" on the rise of the stock and therefore all verges towards speculation. However the low P/E stocks are those to expect the highest possible returns, also at triple digits. capitalization, that is, the market value of the company calculated by multiplying the number of shares outstanding per the share price.

Large companies with a strong brand and a proven history of profits

4.

have to be preferred. In any case this is a less important point than the previous two.

Dividend yield, i.e. a measure to understand if the company pays dividends, which is a way to be sure that at least a return by dividends can be obtained, though this can be understood also by a high value of ROE, as already said. But sometimes high dividend yield stocks do not show high values of ROE (Santander, Enel, Vodafone, Gazprom, Gas Natural).

We strongly repeat: put your attention on the 10-year average of net profits and it is very likely that you will avoid the most common mistakes that are generally made in the purchase of stocks.

Calculate the 10-year average earnings of the company and, if this average is negative, put the company stock in your trash can and do not consider it for the next 2 or 3 years. Using this method it is likely to throw away the 70% of all listed companies in the world!

With this fundamental system in our hands, we are now able to come up with an index that would allow us to compare every single stock with another to understand which one is more convenient for an investment. Assuming the four criteria mentioned above already sorted in order of importance: ROE, P/ E, capitalization and dividend yield, we can propose the following index:

(ROE)3 * √ Capitalization

* (1+DividendYield)4

(P/E)2 In this way, we put the main emphasis on large values of ROE, then on small values of P/E, then large values of capitalization and high dividend yields. We decided to apply the square root to the capitalization to not prefer in any case large companies, but just those showing also high values of ROE and small values of P/E. Otherwise we would choose a company just because it has a big dimension.

As for dividend yields, we decided to add 1 to it in order to not exclude a company just because it does not pay any dividend. We decided also to power the dividend yield + 1 per 4, otherwise – as understood by some empirical trials - the incidence of dividend yield would have been negligible, because if !60

two stocks pays dividends probably the difference in their dividend yields will not be very high, as both will be near 5% gross. In any case we will give even more importance to those stocks which provide dividends and leaving unchanged the index for stocks that do not pay them at all. In addition, the higher the dividend, the greater the multiplication factor and the better the final repositioning of the stock in our personal ranking.

So in general terms the values of the dividend yield does not vary much from one stock to another if both pay dividends. Should a stock have a dividend yield of 20% it would mean that the stock returns every year a 20% at the current price even without considering a possible revaluation of the stock price. It follows that this number will typically be of the order of the interest rates of alternative fixed-rate instruments, so in our day around 5% gross.

The following is the list of the best indices (AII column – Aware Investor Index) obtained on May, 12th 2013 (you can view the complete and updated list on the website: www.theawareinvestor.com):

!

In this way we have a measure of how a company is more attractive than another. The AI Index has been reported with 4 decimal digits.

From our experience, the value of the overall index should be interpreted in this way: Index Value More than 100 !61

Interpretation Great investment opportunity

Between 10 and 100 Between 1 and 10 Under 1

Good investment opportunity Not bad investment opportunity Not attractive opportunity, to avoid

We show now the process that led to the calculation of the index for The Western Union Company.

The starting point is to identify the net profits of the last 10 years (in million $): 2012: 2011: 2010: 2009: 2008: 2007: 2006: 2005: 2004: 2003:

1,025 Mln $ 1,165 Mln $ 910 Mln $ 849 Mln $ 919 Mln $ 857 Mln $ 914 Mln $ 927 Mln $ 751 Mln $ 633 Mln $

(1) (2) (3) (4) (5) (6) (7) (8) (9)

The 10-year average earnings are 858 million $ each year.

Number of shares outstanding at the end of 2012 = 607 million.

EPS (10-year average earnings per share) = (1)/(2) = 1.41 $ Stock price at May 12th 2013 = 15.99 $ P/E = Stock Price / EPS = (4)/(3) = 11.31 Equity = 940 million $ ROE = 10-year average earnings / Equity = (1)/(6) = 0.9131 (91.31%) Dividend per share = 0.5 $ Dividend Yield = Dividend per share/share price = (8)/(4) = 0.0313 = 3.13% (10) Capitalization = (2) * (4) = 9,712 million $ Index = [(7)3/(5)2] * √(10) * (1+ (9))4 = ( 0.9131 3 / 11.31 2 ) * √9,712,000,000 * (1+0.0313) 4 = 663 !62

Similarly, you can calculate the index for your own stocks.

Let now see what the returns were in 2012 on the best ten stocks identified, considering only those with normal P/E values (at least near 15), because those with low P/E values have entered in our ranking mainly because they have suffered a great price drop in the last months.

Company

Price on Jan 1 2012

Price on Dec 31 2012

Stock price return

Dividend Yield

Total return

HCA Holdings

22.03 $

30.17 $

36.95%

29.5%

66.45%

Lockheed Martin

80.90 $

92.29 $

14.08%

4.43%

18.51%

Philip Morris Intl.

78.48 $

83.64 $

6.57%

3.63%

10.20%

BT Group

1.91 £

2.31 £

20.94%

4.97%

25.91%

Altria Group

29.65 $

31.44 $

6.04%

5.16%

11.20%

114 $

116.67 $

2.34%

5.30%

7.64%

GlaxoSmithKline

45.68 $

43.47 $

4.84%

5.57%

10.73%

DISH Network

28.48 $

36.40 $

27.81%

3.51%

31.32%

McGraw-Hill

45.67 $

54.67 $

19.71%

7.70%

27.41%

Intercontinental Hotels

12.4 £

17.07 £

37.66%

3.36%

41.02%

Average

7.31%

24.04%

Lorillard

So, the best stock (HCA Holdings) would have offered a 66.45% annual gain, while the worst stock would have offered a 7.64% gain and a portfolio made of equal portions of the 10 stocks would have offered a gain of 24.04% for the year, much better than the gains you can find among fixed-income alternative investments. If you considered also the low P/E stocks the gain would not have been so good; this because the index we have calculated is more related to a possible future performances the stocks identified can offer rather than on performances they have offered in the past. So on the stocks identified we expect better returns than those offered in 2012 for the years to come. For example Western Union has entered in our ranking just because it !63

has suffered an important price drop. And this applies even more also to ITT Education, Cellcom Israel and Strayer Education.

As a further analysis of the performance of our 10 stocks, let us calculate the overall gain for the last 5 years just regarding the stock price; for dividends the calculation would have been more difficult, because the dividend yields are different year per year and they must be calculated for each year considering an initial different price.

Company

Price at Jan 1, 2008

Price at Dec 31, 2012

Overall Gain

Yearly Gain

31.12 $ (Mar 10th

30.17 $

-0.03%

0%

Lockheed Martin

78.78 $

92.29 $

17.15%

3.43%

Philip Morris Intl.

49.15 $ (Mar 17 2008)

83.64 $

70.17%

14.03%

2.65 £

2.31 £

-12.8%

-2.57%

Altria Group

21.37 $ (Mar 31 2008)

31.44 $

47.17%

9.42%

Lorillard

72.76 $ (Jun 9 2008)

116.67 $

60.35%

12.07%

GlaxoSmithKline

50.29 $

43.47 $

-13.56%

-2.71%

DISH Network

33.48 $

36.40 $

8.72%

1.74%

McGraw-Hill

40.81 $

54.67 $

13.86%

2.77%

Intercontinental Hotels

8.75 $

17.07 £

95.08%

19.02%

Average

28.61%

5.72%

HCA Holdings

BT Group

The 7.31% dividend yield gained in 2012 on the stocks above is something exceptional, because it depends on the extraordinary dividends paid for HCA Holdings and McGraw-Hill; so we think it is not repeatable in the years to come. So, considering an average dividend yield on our stocks at a more normal 3.5%, supposing we registered the same dividend yield each year in the last 5 years, we can assume an annual average gain on a portfolio composed by equal weights of the 10 stocks identified at 9.22%, and an overall gain for the !64

last 5 years at 46.11%, not bad if compared to alternative fixed income investments and considering that the performance was obtained in years experimenting two huge financial crisis due to sub-prime mortgage loans in 2008 and sovereign debt in 2011.

What highlighted shows us that high-ROE and not overvalued stocks (not excessive P/E) are able to register stable returns during the years, while those with current low P/Es have obviously registered huge losses in the past years.

But we are willing to invest on them only now that their price has dropped dramatically.

As you may have noticed the returns obtained are not exceptional, though stable; if you want to try to achieve exceptional returns, you have to invest a part of your portfolio on low P/E values stocks, always considering they can be risky because these would be companies suffering hard times and which could overcome or not the current difficulties. In the next chapter we highlight just this aspect.

In any case, if you have a short term perspective, you cannot invest on high ROE stocks with high P/E because, even if they have the potential to offer you an high return, this would probably translate in high stock price only after at least a year or two, because an high ROE says us that the company has the potential to obtain increasing earnings for the years to come, but not that an immediate increase is going to occur. So the risk is to invest in stocks which could have in the immediate also an alignment of P/E to lowest values, coming back after one year or more to high prices. For example in February 2013 we have experienced the downturn of McGraw-Hill and Moody’s due to the US governmental action toward rating agencies about ratings given before the subprime crises in 2008. Moody’s for example was selling at a P/E of 25 on its 10-year average earnings and after the news about the action emerged, it lost 20% of its value in two days, bringing its P/E at 20. A long term investor would have not sell the stock, convinced of the worthiness of the stock for the years to come, but a short term investor would have been quite upset by the situation and would have been tempted to sell the stock. So, if you have a short term perspective you have never to invest in high P/E stocks, even if they have exceptional ROE values.

It could help to devise a chart made of nine distinct areas each corresponding to a different combination of bands of ROE and P/E. If we put on the x-axis three bands corresponding to low values of ROE (say under 15%), medium values of ROE (say between 15% and 25%) and high values of ROE (say more than 25%) and if we put on the y-axis other three bands corresponding !65

to low values of P/E (say less than 10), medium values of P/E (say between 10 and 30) and high values of P/E (say more than 30), we could obtain a schema as the following in figure 18.

The most convenient stocks should be those in the bottom right quadrant of the schema, as they are both long term and short term stocks. These are generally inexplicable cases, for example as ITT Educational Services; they have never shown a negative income, but are selling at a 2 P/E, perhaps because they are not paying dividends, obtaining high values of ROE with a strong stock repurchase.

The stocks in the other two bottom quadrant are most suitable for a short term perspective, as they are undervalued but with moderate or low long term perspective.

The stocks in the middle-right quadrant are suitable for a long term perspective, because they are all fairly priced stocks, but with an high potential for the future; the stocks in the top-right quadrant could be dangerous because their long term potential could be already discounted in the price, as they are overestimated stocks.

Facebook Amazon

GoogleMastercard

+ P/E

Apple

Inditex SAP

Oracle L’Oreal Verizon Adidas

Walt Disney Pfizer K+S Novartis Nike Philips Dow Chemical Xerox

-

Munich RE Shell Porsche BP Repsol HP Ing Groep Renault

-

Hugo Boss

BHP Billiton Home Depot Wal-Mart Unilever P&G Eli Lilly Pepsi Co Harley D. Intel American Ex. Exxon Nestlè Coca Cola Audi Total

Astrazeneca Marks & Spencer Best Buy

ROE

Accenture UPS

Verisign

Colgate Palmolive

Boeing Roche Philip Morris Moody’s IBM Lockheed Martin Swisscom Western Union Dell Nokia

Cellcom Israel ITT

+

!66

Figure 18 – Chart with stock positioning related to the two dimensions of ROE and P/E

The worst stocks in which to invest should be those in the upper-left quadrant, as they are both overvalued and with low long term perspectives.

In any case all the stocks in the picture are at least companies with positive 10year average earnings. Stocks with negative 10-year average earnings are considered garbage and to be avoided for an investor.

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How to compose your own stock portfolio

We have said throughout the text that an investor must have a long-term investment perspective; therefore the main part of your portfolio should be invested in equities with a high ROE. Based on the principle that you should not invest the savings that are necessary for your daily live, but only the excess, we believe that the capital has to be invested for the 80% in equities with a high ROE returning dividends, and 20% in stocks with low P/E that could be included in the normal range of P/E by recording above-the-norm returns. For example, a good portfolio of an investment of € 100,000 and obtained by referring to the rankings presented in the appendix, we think would be as follows:

Percentage of capital

Amount of capital

Stock

ROE

P/E

10%

10,000 €

HCA Holdings

>100%

14.97

10%

10,000 €

Lockheed Martin

>100%

14.95

10%

10,000 €

Philip Morris

>100%

22.09

10%

10,000 €

BT Group

>100%

16.05

10%

10,000 €

Altria Group

>100%

21.47 !68

10%

10,000 €

Western Union

91.31%

11.31

10%

10,000 €

Lorillard

>100%

18.56

10%

10,000 €

GlaxoSmithKline

63.67%

19.10

5%

5,000 €

Safe Bulkers

28.80%

3.15

5%

5,000 €

ITT Educational

>100%

1.97

5%

5,000 €

Cellcom Israel

>100%

4.25

5%

5,000 €

Nutrisystem

60.90%

6.56

As you can see, all the stocks with a high ROE rarely fall much below the value of 20 P/E, so we get a further confirmation that valid long-term companies are almost never underestimated, and in some cases are quite overvalued, as in the case of Colgate Palmolive that travels around a P/E of 30. Only Western Union navigates at a low P/E of 10. The P/Es obtained are sometimes near 25, higher than the value of 20 we had fixed as a right price.

This could be due to the fact that we have used the 10-year average to calculate it and not only the earnings of the last year, so the calculation was made in a quite conservative way.

With our system we are still investing in companies that in the past 10 years have made good profits and therefore no negative average in the last 10 years earnings; so even companies that are in the second group are still valid companies in comparison to the enormity of worthless stocks often found listed on the financial markets, which make no profits, do not have a story behind them and do not offer dividends... We have decided to put a 5% on Safe Bulkers, ITT Educational Services and Cellcom Israel and Nutrisystem, because they show both a low P/E and a high ROE, leading them to the top positions in the overall classification of our overall index.

It must be said that the rankings obtained must not be taken literally, but an investor should also choose those that she thinks are most suitable to her, in terms of field of business, brand, company’s history and so on. So the first stocks of the ranking can be picked differently by each investor.

Regarding the exit strategy, i.e. when a stock in the portfolio should be sold, we suggest to sell a stock only when it reaches a very high P/E, for example greater than 50 which would mean that the stocks is greatly overvalued. As soon as an investment in a stock should start recording high profits with a P/ !69

E at very high levels, we suggest to sell it and go to increase the capital invested in the stocks with a high ROE but a moderate P/E. For example, though not likely, but should ITT Educational Services be suddenly overvalued by the market registering a P/E over 50, our â‚Ź 5,000 would have become almost â‚Ź 120,000, money that you have to recover by selling the ITT stock, which has now completed its purpose, and purchasing other high ROE stocks but not overvalued, for example, distributing â‚Ź 10,000 on each of the stocks of the first group which in the meanwhile have not been overvalued, or going to buy other different stocks of our ranking. This exercise is left to the investor, who will decide on what stock to improve the position under the certain moment of the market, according to the principle that always at each time certain stocks are more undervalued than others by the market.

Proceeding in this way also reduces the portfolio risk because we sell a stock and with the same money we invest for example in another 5 or 10 different stocks, so to record losses in the investment we should have been wrong not on one stock, but on 5 or 10 different stocks, which is surely less likely.

On the contrary, however, if you purchased a stock that does not pay dividends at a very low P/E, should the company go back to pay dividends, the price would return to normal values and those who bought at very low P/ E would record very high dividend yields. In such cases the investor should not sell so lightly, not to deprive herself of the privilege to start receiving high dividends; privilege that would be lost immediately selling the stock. In general we believe that, apart from special cases, in which actually the company's future is not clear, maintaining a stock in the long term is the strategy that definitely pay more on the long run.

Some strong-brand stocks should be kept also when the P/E is very high.

Take for example Moody's. This is a stock by the outstanding brand, with a high ROE. If you had the chance to buy it at a moderate P/E around 20, it is absolutely treasure, because this kind of stocks generally trade at very high P/ E, because they should already contain today in the price future profits. Stocks such as Moody's have to be maintained even with a high P/E around 50. In this case, we are confident that the stock is not only overrated because of the brand, but also because there are underlying financial values that support the share price, not as trendy stocks such as Linkedin, Facebook, Amazon and others.

Another reason to sell one stock could be due to new financial data gathered about a certain company that let us understand that the conditions for which we had bought it are no longer valid. In this case we probably will suffer a loss on our investment, so this is the worst scenario for our system. !70

It is to warn the reader, however, that there is no need to expect an immediate upward by stocks of low P/Es. An investor might think: I invest in this stock with a P/E of 3, so in a short time I have in my hands 5 times the money I spent. Unfortunately it is not said. Observations of the markets we have done in recent years, let us know that often companies with low P/Es remain so for years, until they revert back into favor in the eyes of a large number of investors. Stocks such as Ing Groep and Renault, for example, are traveling now for 3-4 years with a P/E of less than 5 and no one can predict if and when they will return to "normal" levels of P/E, for instance around 15. So using a small part of your fortune on this type of stocks may be fine, but definitely not good to employ the most important part of the portfolio on them, as repeated several times till now.

However the information of the P/E should not be underestimated than the ROE. In fact, it provides us with an important assurance that the price of a stock cannot go down to 0 so easily and so lose all our money. Sure, a company can fail and then we lose all the money we invested in its stock, but to lose all our money all the companies that we have included in our portfolio should fail. And generally, you will suffer big losses when you invest in stocks with very high P/E, possibility that is excluded by our index because in any case in the overall convenience the value of the P/E is considered, and stocks with a too high P/E are necessarily to be in the last positions, even if they have high values of ROE. If a stock is priced with a P/E of 60 and should suddenly fall to the normal range, for example 20, then we lose 70% of the initial capital. But the stock market can be unpredictable, we can also invest in a stock with a very low P/E of 3, but this stock could still go down to a P/E of 1, and then we lose, however, 70% of the money invested on it, though certainly as said throughout the text it is a less likely hypothesis than the previous. However those who invest on the stock markets cannot be afraid when the money invested in a stock falls by 10 or 20%; if an investor sells immediately when the loss exceeds a 2-3% because of the fear of losing too much, he or she will find himself or herself to buy back it at a higher price than he or she sold it. In any case, the results should be evaluated over the long term and not on the results a month after the purchase of a stock. The number one rule to operate in Stock Exchanges is to have patience. And if left prices unchecked too often, we believe is the best. Another famous quote by Buffett goes something like this: "Rather than losing days observing the fluctuations of stock prices, I prefer study an annual report to ensure that the conditions under which I purchased are still valid." And again: "For me it would not be a problem if the stock market would remain closed a couple of !71

years without knowing the intermediate prices but only the final one. I evaluate the company, the stock price follows accordingly".

Not checking prices frequently reduces the risk of falling into the temptation to sell and move your wallet too much. Selling shares because we do not get gains immediately on them is wrong, because often share prices remain stable for long periods, but within a matter of minutes can instantly record doubledigit increases, with the risk of not having them in our hands when this increase occurs. Huge gains are achieved over the long term, remaining in the market as much as possible, as long as convenient and valid shares are purchased.

From our experience, the stocks for which there is a great opportunity to achieve above-the-norm gains are those which travel around a P/E of 1, because in these cases either they are companies that fail (and then you lose everything invested) or the stock price must rise at least around a P/E of 4 or 5 for a low but not ridiculous price. It is exactly what happened to Ing Groep and Genworth Financials in the periods analyzed in the chapter on the design of our system. When a company records a P/E near 1 it is likely that we are dealing with a case in which investors have exaggerated with selling and have sold more than any negative logic, then repurchasing in the following days to realign the price at a P/E still less than the minimum but over 1. However stocks with a P/E around 1 are very rare and therefore they are not chances that occur often, and even then they do not necessarily prove to be a success.

One of the cases in which we have adopted this technique, in fact, was that of Lehman Brothers, which we all know has been allowed to fail by governmental organizations worldwide, case that has not happened for Ing Groep, which was rescued by the Dutch state that granted it a bridge loan to avoid the domino effect that has instead occurred after the collapse of Lehman Brothers. When a large company fails the effects throughout the global financial system are devastating, as actually happened in 2008. However on companies with low P/E there is usually something wrong and then it is almost betting on rising and all verge toward speculation. In these cases it is also virtually impossible to try to understand what is the real liquidity situation of the company, because the company's website certainly does not provide critical information in this regard and newspapers or media can only make predictions, they do not possess the information that only the directors of the company (and often not even them!) possess. For example, the day before the failure, Lehman Brothers presented a statement outlining a series of measures to overcome the difficult times, and finally was officially admitted that there were difficulties. Personally, as soon as we came across the news we managed !72

to sell, but that did not stop us to record a loss of 50%. However, the day after the release of the statement with the list of points to be taken to the recovery, the company failed, because everyone started to close open positions and investments and the company found itself in the situation to reimburse at once the most investments that he had accepted from the outside. The only way out would have been a help by governmental organizations that were supposed to provide the necessary liquidity to absorb the demands of investors who wanted their money back. But also because of the negative public opinion of that time in respect of investment banks, such aid did not arrive. Strangely, after the Lehman Brothers case all governments have made their way to save the greatest number of large banks in the world!

It is to emphasize that when a company goes bankrupt, suddenly the website of the company does not deliver any more news, and to understand that a not well known company is failed, you often have to do some research on specialized web sites that list the cases of insolvency registered. This we believe is absolutely unethical and it is a scam to investors, because it does not allow non-professionals to get out of a stock in time when these situations occur. In this sense we believe that regulations and severe penalties should be established for those who do not promptly notify their critical situation of liquidity or in the extreme case of bankruptcy.

The P/E theory allows us to understand another fundamental property of stocks, namely that the stocks does not have an upper limit to the gains that they can offer, but they have a lower limit below which they cannot get off.

Precisely the maximum loss that can occur on a stock is 100%, or lose everything you have invested in it, but at the same time there is no upper limit, because a stock may move from a P/E of 1 to a P/E of 20, and then let us record a gain of 2000%! Or go from a P/E of 2 to a P/E of 50, and then let us earn 2500%. However, if the investment goes in the worst way, we lose the 100% of our investment, we can never lose more than what we have invested in the stock. This we believe is a very important point in favor of stocks when compared to other financial instruments.

It should be added that the portfolio shown in Figure 17 is an approximation.

Each investor can decide for herself the portion of capital to be allocated to companies with high ROE and those with a low P/E. We personally recommend you do not fall under a percentage of 80% invested in high ROE stocks, indeed we believe that investing 100% of the capital in high ROE and not undervalued stocks only, (so with normal P/Es) is even more reliable and successful. Under this second chance our portfolio may change as follows: !73

Percentage of capital

Amount of capital

Stock

ROE

P/E

10%

10,000 €

HCA Holdings

>100%

14.97

10%

10,000 €

Lockheed Martin

>100%

14.95

10%

10,000 €

Philip Morris

>100%

22.09

10%

10,000 €

BT Group

>100%

16.05

10%

10,000 €

Altria Group

>100%

21.47

10%

10,000 €

Western Union

91.31%

11.31

10%

10,000 €

Lorillard

>100%

18.56

10%

10,000 €

GlaxoSmithKline

63.67%

19.10

10%

10,000 €

DISH Network

>100%

22.20

10%

10,000 €

McGraw-Hill

91.65%

20.59

In this way we have our portfolio invested in stocks that return dividends and we can probably leave them intact for years, controlling only from week to week if something is going to happen to stock prices and once a year when entering new balance sheet data for the year just ended. Data that modify the average earnings, equity and therefore ROE and P/E, thus leading to a new value of the index that should be checked.

We may finally ask why not invest all our money in one only stock, the one that shows us the best ranking. This we believe is unwise, as the best stock identified today may, though not likely, for any reason be involved in a sudden downward spiral because of legal actions against the company, a sudden decline in the brand or other. So you should always try to diversify your portfolio by investing in a dozen of different stocks, selected from the top positions in our charts. We suggest, on the other hand, to not abuse with diversification to avoid making your portfolio unmanageable. If Warren Buffett, with billions of capital available, does not exceed a dozen of stocks in his portfolio, we believe that in our case we can be satisfied with such a number, for better focusing and not investing in stocks in too low positions in our rankings. !74

With regard to the timing of the investment we advise you not to invest in only one step all your available capital. In fact, if we were to start investing in one step all our portfolio, we could face a period of generalized high prices with the risk of recording in the weeks immediately following a loss on our investments just because the global macroeconomic conditions have deteriorated, then having to recover in the following months this initial handicap and not having capital available to invest when share prices in general have dropped.

Therefore we believe it is wise to start investing in a first part of high-ROE stocks few days after the payment of dividends, i.e. after the speculators have left the stock, and then investing in low P/E stocks starting with those with the lowest P/E possible.

There is no standard procedure, the investor must also use a little of “sixth sense”, but a hypothesis of an initial investment of € 100,000 in the first portfolio assumed to be achieved in 3-4 months could be for the first month as follows:

Date 1st Week

Total 1 2nd

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Capital

Stock

P/E

Event

3,000 €

Lorillard

16

Lorillard has just paid dividends and P/E has dropped

3,000 €

ITT Educational Services

2

ITT remains with a ridiculous P/E

3,000 €

Western Union

11

Western Union remains with a low P/ E

3,000 €

HCA Holding

14

Available at a good price

3,000 €

Lockheed Martin

15

Lockheed available at a low price

15,000 € Invested 3,000 €

BT Group

16

BT Group available at a good price

3,000 €

Cellcom Israel

4

Available at a very low P/E

3,000 €

Nutrisystem

6

Remains at low P/E

2,000 €

3,000 € / 6,000 €

Total 2 3rd

2,000 € / 5,000 €

3,000 € / 5,000 € 5,000 €

4th

Glaxo remains at a fair price, we buy, but not so much.

Western Union

11

Western Union remains with a low P/ E

ITT Educational Services

2

It remains ridiculously low. Purchase completed.

Western Union

11

Western Union remains with a low P/ E. Purchase completed.

GlaxoSmithKline

18

Glaxo price dropped.

We buy again.

Safe Bulkers

3.5

Decreased a little bit more. Purchase completed.

43,000 € Invested 2,000 € / 5,000 €

Lorillard

17

It remains enough low.

We buy again.

2,000 € / 5,000 €

Cellcom Israel

3

Even more convenient.

Purchase completed.

BT Group

15

BT even more affordable.

2,000 / 5,000 € Total 1

19

29,000 € Invested

4,000 € / 10,000 €

Total 3

GlaxoSmithKline

49,000 € Invested 51,000 €

Yet to invest

Note that at the end of the first month we have not yet invested in Philip Morris, for example, but we have already started to invest almost half of the capital available. In the following months we will be able to purchase in an even more scientific way, as a first base of the portfolio is already set; so we recommend the following months to be even more careful and invest only when a good chance is available and complete the overall investment within the following months. The only stocks for which the investor must hurry in

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buying are those with very low P/Es, because they are those that could register an immediate rise in the stock price.

After one year from the investment of our capital, we can expect, regardless of whether or not capital has appreciated, even an income from dividends that we can assume at most around a 3% net (after payment of taxes) on the highROE stocks. Presumably we should not expect any payment of dividends on low P/E stocks. As we have invested, according to the first hypothesis of portfolio, € 80,000 on high-ROE stocks, the liquidity that we expect from the dividend payment is at maximum approximately about € 2,500 net per year that we can still decide to reinvest in our portfolio or for use in our daily needs. It is clear that those who have large sums of capital to invest will not invest on low P/E stocks, but only on those with a high ROE, since only the dividend payment can produce almost all the cash needed for daily life (think at 1 million € invested in high-ROE stocks which could return – at a 3% net dividend yield - € 30,000 net dividend without regard to any revaluation of stock prices).

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Importance of ownership of stocks for long periods

The financial concepts set out above are certainly important, but they are actually secondary to another type of concept, rather "behavioral", which is to minimize the handling of your portfolio and if possible buy shares to keep them "for life", i.e. tens of years. Even a normal stock, if maintained intact for years can give us great satisfaction when evaluated on the overall yield which was able to offer us either as dividends or as price increase. And if you buy stocks with the best financial metrics and with big brands, keep them for many years leads to a result almost to be taken for granted.

After an appropriate financial analysis, as proposed by this text, we must not be afraid to buy the best stocks identified, but instead to have to think a lot before selling, at least for the following reasons:

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-

If you are recording a gain on the stock, selling it immediately means to lose a 20% (depending on the country of residence) of taxes on capital gains, which otherwise would remain invested.

Selling it also means paying commissions out from the bank; selling it also means having to repurchase later and then pay other fees for entrance to the bank!

-

If you sell and then buy back at a higher price after some time, the dividend yield you get is decreased. A Philip Morris stock purchased at the 2009’s price would return today a dividend yield of 10%,

whereas purchased at a 2013’s price would return a dividend yield of only 3%. For stocks with a high dividend growth this error is unforgivable.

-

Selling a high-brand stock such as Moody's, purchased at an affordable price, is criminal; it may not occur again the chance to buy it back at a favorable price. Such stocks have only to be sold at unacceptably high P/Es, for example above 100. A shareholder of these companies must be jealous of his stocks that are sought after by investors around the world. In these cases you should sell only for an offer you cannot refuse. It's like owning a business created from scratch by you and be in front of a buyer who wants to buy all at a normal price. Obviously you do not accept at a figure that will not change your life.

-

Selling a stock to keep the money in a corner, unused, is foolish.

The money invested in a valid stock is being yielded by the underlying company, besides the chance of events such as acquisitions that may make the stock price rise in a short time.

Selling a stock can be acceptable only if there is another more convenient stock that you absolutely want to buy.

-

If you sell for the fear of a global crisis, it is likely to remain out of the market in the period in which certain stocks could record sudden increments.

-

Usually stocks remain stable around the same price for months, to suddenly record, even in a few minutes, increases also at doubledigit percentages. Selling because you are tired of waiting for a gain, could result in the fact that you stay out of the market just in the few minutes in which the increase occurs.

Adopting an approach of this kind also allows you to not have to constantly monitor the trend of stock prices that you have in your portfolio. You can devote your time to the main activities of your life and even weekly check your wallet, pocketing dividends from time to time without even noticing it!

Being shareholders means being owners of companies, entrepreneurs, and the more stocks are maintained in the long term and the more an investor put herself in a perspective of this kind; this perspective is particularly attractive for investors with a fixed-salary job. In the current macroeconomic environment, in fact, we can record a widespread criminalization of workers at fixed salary compared to other categories of workers, such as self-employed or !80

entrepreneurs. Fixed wages remain stationary , while the cost of living, in terms of taxes and rising prices of consumer goods, is constantly increasing.

The recovery of the economy seems to manifest itself in our days not by a decrease in unemployment or an increase in wages, but rather in an increase in profitability for the owners or shareholders of the companies. The economic conditions of employees do not seem to improve in line with those of the economy. The only way for workers to avoid this penalty is to find some way to get them even to the ownership of companies. Stocks are just ideal for this purpose...

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A possible guarantee as protection to your portfolio

Certainly adopting a long-term perspective allows us not to fear too much on momentary dips in markets. We know that, apart catastrophic events, longterm investments in the best stocks produce higher returns than other financial instruments. But this is not enough.

We want to be always sure of the money we have available, and we need to protect it in exceptional cases and unlikely generalized collapse of the markets regardless of the goodness of the stocks in the portfolio of choice: world wars, States going default, distortions of the fundamentals of economics.

We want that in the case in which highly improbable phenomena occur, having the potential to disrupt the status quo of the economy and thus lead to disastrous collapse of the markets, as occurred in 2001 with the dot-com bubble and September 11, in 2008 with the sub-prime mortgage bubble and in 2011 with the crisis of sovereign states, our money is always protected.

At the moment the threats that could explode could be the following:

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•

Event of a U.S. default after the days of "shutdown" occurred in October 2013

•

Bubble of student loans, who are not able to pay them back due to the decrease in salaries offered to top-school graduates.

•

A World War also with non-conventional weapons (cyber warfare or knowledge war?), for example after the cooling of relations United States/Russia following the Snowden case.

For this purpose, we believe that the most useful financial instrument to be used and the only derivative to accept, and only as a precautionary measure, is the Covered Warrant.

It is a financial instrument to bet on the fall in price of an underlying asset, which can be a stock, an index or another listed instrument.

Covered Warrants in general are options that allow us to have in hand a tool that allows us to buy ( call ) at a specified price (strike price) or sell (put) at a specified price the underlying instrument within a certain date. Specifically, the "put" type of covered warrant allow you to exercise the option to sell an instrument at a specified price (strike price) before you buy it and buy it only if its price is lower than the strike. In the event that the price of the underlying does not fall below the strike price of the option, it is simply not exercised. As an added feature, there is an indication of a multiplicative factor that indicates how many times the deviation of the price of the underlying from the strike price must be multiplied to obtain the option value. So this is exactly what is right for us, that is a tool that we can exercise in case there should be an indiscriminate collapse of the markets.

But all this does not come without a cost. Covered warrants - and options in general - have a cost that depends on a few factors: the current price of the underlying instrument, the days until the expiration date of the option and the target price. There is a famous formula for determining the price of an option, the Black-Scholes formula, among other things, very complex and studied by specialists in Quantitative Finance. Obviously we do not care to know or apply the formula, simply because the covered warrants are traded on markets such as equities, and so it is the market that determines the price, of course around the right price determined by the Black-Scholes formula.

For example, a “put” covered warrant on a stock could have the following features: •

Deadline: End of June 30, 2014

•

Strike Price of the option: $ 25

•

Multiplier 0.1: that is, any deviation downward by $ 1 from $ 25 strike option is worth 0.1 $

Let’s take for example the following warrant !84

! : It is a “Put” type of Covered Warrants on the FTSE 100 of London, it expires on 20/12/2013, has a strike price of 6000 and a parity of 1000.

Let's understand what does it mean.

By purchasing a covered warrant of the type above, we have the right to sell by 20/12/2013 at 6000 a FTSE 100 share that today is 6337,908 and buy it back at a lower price than 6000 as we bet on its decline below the strike.

Let us now calculate the return we can get . Let's say we bought 1000 Put CW of the type above for a total of 110 pounds (1000 x the ask price which is 0.11). If there were to be a catastrophic event for which the FTSE 100 falls down to 5000 points, we get a difference to the strike (which is 6000) of 1000 points. Since parity is 1000, with 1000 points of difference, each individual warrants will be worth £ 1. Since we have 1000 Put CW in hand, we would find ourselves with £ 1,000 . So we paid £ 110 and get £ 1000, in the event that the FTSE 100 were to lose 20% by 20/12/2013 . In the event that there would be a catastrophic event such as a world war , the FTSE 100 could drop to 2000 for example , and therefore our 1000 CW Put would be worth £ 4,000. If we have a portfolio of £ 100,000, to protect all our capital we would need 25,000 Put CW, for which we should be spending £ 2750 Put CW to protect our portfolio, i.e. about 3% of our money used as insurance. As we said, everything has a cost. Maybe a little too high in this case. At year-end , if the catastrophic event has not occurred, we would have lost 3% of our portfolio. If on our stocks we recorded a gross profit of 30 % in the year , the total return will be reduced by 3%, to stand at 27%, still not bad.

To reduce the percentage of capital employed as insurance, you might think of buying a put covered warrant with as underlying some of the most overrated stocks of the moment: for example Facebook or LinkedIn . In fact, in moments of panic in the markets, the stocks that are most affected by marked sales are the ones that have been excessively overvalued in the past.

For example, there are at least the following Put CWs on Facebook:

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!

We must look for the CWs that have the lowest price possible, so that they cost us as little as possible. Obviously the prices of Put CW are lowest for the least likely events, for example with a strike $ 25 by 20/12/2013 . But we are interested in these very unlikely cases that become probable only in the case of unpredictable shocks in the markets .

For example 10,000 CW of 3824S type could be bought for 300 €. The list does not show it, but the CWs above have a parity of 4:1, i.e. for every $ 4 of Facebook price deviation under $ 25, each CW is worth 1 €. In the event that a catastrophic event were to happen and the price of Facebook were to fall to $ 9, there would be a deviation from the strike price of $ 16 which is $ 25, and our 10,000 Put CW would be worth € 40,000, so to protect a € 100,000 portfolio only 750 € would be sufficient, i.e. less than 1% of our capital. Not bad.

So we are sure that we can protect us well from catastrophic events also employing as insurance even less than 1% of the capital.

To use less money on the protection you need to buy Put CWs close to expiration date, i.e. far not more than 6 months from the deadline, otherwise you would be paying a price too high. Then this implies that roughly every 6 months we must purchase a certain number of Put CWs proportionate to our portfolio. We also recommend buying them in times of market euphoria, at times when all bets upward, as we will certainly find them even cheaper .

Finally, having held some of these Put CW, in case there should be a significant contraction of the markets where our 750 € Put CW are in the meantime become € 30,000, we could also have a little thought to sell them, but this should not be the main thought when we buy them and above all we

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must not fall into the temptation to use them as a means of speculation, because otherwise we believe that they completely lose their usefulness.

When you buy a Put Covered Warrant you must do that with the thought of never seeing again the money spent. You must behave in exactly the same way as when you do the wire transfer to your insurance company to be protected against car or house damages. With this in mind, Covered Warrants can make us sleep good nights, also if world catastrophic events should occur.

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An example of forced exit: Nokia

As mentioned in the previous pages, Nokia certainly constituted an attractive stock before the acquisition by Microsoft announced on September 1st 2013.

After having plunged into its worst crisis, relegated to a marginal role in the smartphone market, in September 2010 the Canadian senior manager of Microsoft Stephen Elop, who had been head of Microsoft's Business Division and responsible for Office development, was called as Nokia CEO. Famous was one of his early speeches as CEO, representing the situation of Nokia with its Symbian operating system, as an oil rig in the middle of the North Sea gone up in flames.

In February 2011, Elop then decided to go immediately toward the Microsoft Windows Phone platform, and already after this choice the rumors about a possible acquisition of Nokia by Microsoft began to spread. Elop began to work to streamline the company, which involved the release of thousands of employees from the company, also causing social hardships in Finland, the historic homeland of Nokia. Finally smartphones with a good attractiveness on the market as the Lumia series began to be produced. In addition the share in the company Nokia Siemens Networks was maintained, a joint venture with Siemens specializing in telecommunications infrastructures, in particular with regard to 4G networks.

In terms of financial data, the results produced by Elop were not positive, also because of the large investments needed to change the strategy of the business. However, given the renewed appeal of the proposed new products, !89

such as the Lumia 920/925 and Lumia 1020, many investors (including who is writing) were willing to bet on a turnaround in the financial performance .

Everything seemed to let assume that the company's restructuring work was largely completed and that the company was preparing to finally collect the results of all the work and the investments made.

Just at that time, however, the news of the acquisition of Nokia by Microsoft was announced.

So Microsoft has remained at the window during the period of the painful restructuring both in terms of personnel and in terms of financial data and as soon as he saw the gathering of the efforts made, he proceeded to the acquisition, finally confirming the rumors for years now. The deal took place on the following terms : Microsoft acquires the Devices & Services division of Nokia for 7.17 billion dollars in the first quarter of 2014. The Nokia brand will disappear from phones replaced by the Microsoft Lumia brand. Microsoft also buys all licenses owned by Nokia. So at the end of the acquisition Nokia will own only Nokia Siemens Network, which in the meantime had been purchased in full and renamed Nokia Solutions and Networks (NSN).

Personally, after we just identified a broad outline of the agreement, we immediately decided to leave the position, on the reasons that now we're going to highlight.

Before the acquisition the value of Nokia's capitalization was $ 15 billion , registering a P/E to 10 years of 4. So potentially, at a time when the company were back to make substantial profits, Nokia could have had also a market capitalization of € 80 billion to arrive at a normal P/E of 20 ( € 15m x 5).

And consider that in its heyday, Nokia had achieved a market capitalization of approximately € 150 billion! Thus, whereas the outlay of Microsoft was only 5.44 billion €, we understand that the big bargain was made by Microsoft and its shareholders and that Nokia made a bad bargain, suddenly finding itself without its main business. So after the acquisition, the analysis of Nokia no longer makes sense, because the gains that were made in 2007 related all to phones, business which now no longer it owns... Moreover, considering that after the acquisition Nokia is practically composed only of NSN, and considering that NSN reported in the last year € 700 million of net earnings, Nokia could be worth around 0.7x20 = 14/15 € billion , representing an already lower than the current capitalization which is € 20 billion.

Personally we sold immediately and, fortunately, the market had attributed a 40% in surplus to the Nokia stock, although, personally, we thought the !90

opposite, given the terms of the agreement markedly unfavorable for Nokia.

However, a 40% yield was obtained in 8 months.

So, analyzing events from a distance of a few weeks we can say that the terms of the acquisition were definitely too favorable to Microsoft and too unfavorable for Nokia and that Elop eventually turned out to be a Trojan horse sent by Microsoft to get hold of Nokia.

Finally we can say that, at this point, the convenient stock to buy might be Microsoft itself just be because it spent 7.17 billion dollars for a business that could be worth also 150/200 or more ( just look at the capitalization of Apple that touches 450 billion dollars). And yet, even before the acquisition Microsoft was a good stock to invest in, with a ROE of 18%, a P/E of 20, a dividend yield of 2.76% and a market capitalization of $ 280 billion.

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Additional Thoughts

With our system, therefore, the only companies in which it is worth investing are those: • •

• • •

with a high ROE; with an appropriate P/E calculated on 10-year average earnings: that means not overvalued, i.e. with a price not too much higher than 20 times its net earnings per share; that pay dividends regularly; great enough; with not excessive debt;

We think that adopting this conservative approach it is likely to succeed in the investments. As an example, let us look at Figure 19 with the companies that Warren Buffett has bought for his wallet. He bought valuable companies, with a high reputation, a strong brand, which pay dividends, and so on. Buffett has invested in stocks that return dividends, while his company, Berkshire Hathaway, does not pay dividends at all, not a bad system! In any case, the Berkshire stock increased in value by 20.2% each year and the people who have invested in it in 1965 are now billionaire (Figure 20). We think that this table is very instructive to understand that the greatest investor of all time, was able to obtain an average increase of its capital by 20% every year, so this really can be considered the limit of any gain that investors may think of obtaining annually over the long term. If you are able, for a number of years, !93

!

Figure 19 – Stock Investments by Berkshire Hathaway

to increase your capital by 20% each year, you have probably reached the maximum you can get from the financial markets. A 20% annual result may look a not great investment, because you might think that if you invest € 1,000 at the end of the year you will have in your hands just € 1,200, and you have not become rich, but every investor who has invested in the markets in the long term knows the difficulty of reaching a similar result, especially during long negative periods and for a number of years in a row. To make you understand what a return of 20% every year means, we see how $ 1,000 become invested today in 30 years at that percentage of income (Figure 21).

So 1000 $, invested in a financial instrument, which returns 20% of the capital each year, after 30 years become $ 237,376,31 (excluding tax on capital gains to be paid at the end of the period). And this is probably the best you can expect to get by investing in equity markets. If you want to start investing, you should have this clear in your mind. Otherwise your financial experience will turn into a nightmare! If you want to get rich, with a small amount of capital available and in a short period of time, perhaps the arena of equity investment is not for you. !94

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Figure 20 - Return in recent decades to Berkshire Hathaway shareholders

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Return:

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Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year Year

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

20,00% Capital at Start of Year Gain $1.000,00 $1.200,00 $1.440,00 $1.728,00 $2.073,60 $2.488,32 $2.985,98 $3.583,18 $4.299,82 $5.159,78 $6.191,74 $7.430,08 $8.916,10 $10.699,32 $12.839,18 $15.407,02 $18.488,43 $22.186,11 $26.623,33 $31.948,00 $38.337,60 $46.005,12 $55.206,14 $66.247,37 $79.496,85 $95.396,22 $114.475,46 $137.370,55 $164.844,66 $197.813,59

$200,00 $240,00 $288,00 $345,60 $414,72 $497,66 $597,20 $716,64 $859,96 $1.031,96 $1.238,35 $1.486,02 $1.783,22 $2.139,86 $2.567,84 $3.081,40 $3.697,69 $4.437,22 $5.324,67 $6.389,60 $7.667,52 $9.201,02 $11.041,23 $13.249,47 $15.899,37 $19.079,24 $22.895,09 $27.474,11 $32.968,93 $39.562,72

Capital at Year End $1.200,00 $1.440,00 $1.728,00 $2.073,60 $2.488,32 $2.985,98 $3.583,18 $4.299,82 $5.159,78 $6.191,74 $7.430,08 $8.916,10 $10.699,32 $12.839,18 $15.407,02 $18.488,43 $22.186,11 $26.623,33 $31.948,00 $38.337,60 $46.005,12 $55.206,14 $66.247,37 $79.496,85 $95.396,22 $114.475,46 $137.370,55 $164.844,66 $197.813,59 $237.376,31

Figure 21 - Evolution of a stock over a period of 30 years invested at 20% per annum

In the following table we show the positioning of the stocks Buffett has bought in the ranking of the stocks we have under observation.

Company

Position

Index

ROE

P/E

Dividend Yield

American Express

108

3.27

18.18%

23.29

1.14%

Coca Cola

100

3.79

19.24%

30.27

2.66%

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ConocoPhilipps

68

6.31

13.78%

11.69

4.24%

DIRECTV

22

111.74

>100%

41.96

0%

IBM

17

192.51

56.28%

21.86

1.66%

Moody’s

19

155.99

>100%

28.48

0.98%

Munich RE

223

0.51

7.41%

13.31

4.64%

Phillips 66

80

5.05

15.43%

12.17

0.73%

POSCO

159

1.30

7.60%

7.47

2.57%

Procter & Gamble

104

3.38

15.26%

23.71

2.72%

Sanofi

348

0.07

5.87%

33.40

3.25%

Tesco

185

0.90

10.09%

16.84

3.93%

US Bancorp

162

1.26

10.54%

16.01

2.33%

Wal-Mart Stores

73

5.55

16.48%

21.24

2.02%

Wells Fargo

279

0.23

6.00%

21.35

2.31%

The stocks chosen by Buffett are somehow different by those identified by our system; this is due also to the fact that he probably makes also an analysis of brands, market and long term perspectives, while our method gives an important role to the undervaluation of a stock. However, considering that we have 491 stocks under observation, 7 of those bought by Buffett are in the first 100 positions of our ranking and 3 of them are among our best 25 (IBM, Moody’s and DIRECTV), having an overall index greater than 100. Only 4 stocks bought by Buffett would have been rejected by our system because with an overall index under 1 (Munich RE, Sanofi, Tesco and Wells Fargo). All the other stocks would have been considered by our system as not bad investment opportunities.

One of the qualitative criteria Buffett adopts is to choose those stocks for which there is a high likelihood that they will exist from here to 30 years or more. If you are able to identify stocks that will still exist in 2050, it is likely that they will have a price substantially higher than the current one, moreover having paid dividends for 30 years and more! Buffett is keen to invest in those stocks in which he can remain forever, so companies which are likely to continue to survive from now to decades on. One of the main reason to remain in a stock forever is to avoid to pay takes on capital gains. If you as !97

investor buy stocks without never selling them you have not to pay taxes on capital gain but only on dividends and the overall return results greatly increased.

We should add, however, that Buffett was wrong in some of his investments, but he is such an influential person that he is often able to correct his mistakes by changing himself the strategy of the companies he buys. For example, in the 60s he had bought Berkshire Hathaway which was initially a company that operated in the textile industry. He had managed to buy it at an affordable price because the industry at the time was at a critical stage and in any case even Buffett was not able to make it out of the crisis in which it had fallen. So over the years Buffett has managed to transform the company making it first an investment company by acquiring stakes in other companies, then managed to make it the largest reinsurance companies in the world (that is, provides insurance to other insurance companies) and insurance on large natural disasters. Investments not initially successful, such as in insurance Geico for example, he was able to turn into success stories intervening himself in management and making a work of advertising it in any occasion, especially during the annual meetings with investors. Each annual meeting opens, for example, with his strong encouragement to buy Geico insurance policies that he believes the most convenient in the United States.

We must also add that the average annual return of 20% Buffett was able to obtain with his company is not due entirely to his investments in equities.

Indeed, in recent decades the bulk of the return he was able to obtain was due to the field of reinsurance and insurance of natural disasters. Probably in the early years of his career actually returns which he obtained were due to investments in stocks, for example in The Washington Post, American Express and so on, but in recent years it is not so, even if Buffett continues to holds a portfolio in equities and continues with his investments, but these are no longer the main part of his revenues. Therefore public opinion continues to regard Buffett as the greatest investor of all time, when this could be true for the early years of his career, but now he has increasingly transformed himself into a great entrepreneur. One reason for this transformation is that, as admitted by Buffett himself, the more capital is available and the more it is difficult to maintain the same return to investors. One thing is to have $ 1 million to invest, quite another to have $ 100 billion available, it is not so easy to make them fruit returns with only investments in stocks, since one would be the major shareholder and when wants to exit the position at least would experiment a significant decrease in the price since a large part of the outstanding shares would be offered for sale. Setting a minimum selling price !98

would require plenty of time to sell, selling at the best price would see a dramatic fall in the price. However, to get a substantial return by stocks for capital of hundreds of billions of dollars becomes even more difficult.

Some of the advice that Buffet often recommended are as follows: •

Discipline in investments is probably the most important skill. Do not panic in times of market crisis is a skill that only few investors are able to exhibit.

•

Before you purchase a stock ask yourself the reasons that are leading you to do so. Always ask why, but if the answer is: "my neighbor has advised me", the motivation is a bit 'weak!

•

Do not borrow money to invest. Operate at the margin, for example, involves interests that may exceed even 20% per annum, and therefore it will be virtually impossible to make money by investing in stocks, as the best stocks can ensure you at the best a return around the 20% per annum and since it is not said that we will be investing in the best stocks! Thus, the yield obtained through stocks will barely pay the interest on the borrowed money. Avoid borrowing money even if it should be available at low rates, because the repayment of borrowed money takes place at regular intervals, while the share price is unpredictable, and could record the minimum points at the very moment in which you have to repay the debt, making you record large losses ...

We strongly recommend however that you read the annual reports by Warren Buffett, because they are rich in valid arguments on the financial markets and how the world is going in general, so that they are often great teachings. But .. beware of his attempts to sell some of the products of the companies he owns!

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The Philip Morris “case�

Philip Morris deserves a separate discussion, together with those companies adopting the same policy of capital management.

For some years the manager of this company have carried out a program of repurchasing outstanding shares. This means that there are fewer shares on the market, since the shared capital is reduced, implying that there are less shares to be awarded by the distribution of dividends. This leads to a return of more profits in the company itself, even if dividends are distributed because they will be distributed for fewer shares outstanding and the base of shareholders to be awarded decreases. The main consequence for the markets is that there has opened an hunting towards Philip Morris shares, which not coincidentally was one of the best stocks of 2011, an increase of 35%, a remarkable one during a year of exceptional crisis for financial markets. We were not able to find any other company of this size to have been a breakthrough like that. In less than two years Philip Morris shares have risen from $ 50 to almost $ 90!

Let us better show this through the chart of the last years of Philip Morris stock (Figure 22).

Although the P/E is going up a lot, because of the relentless price, the prospects of the company in these conditions are excellent in our opinion, because it maintains a huge ROE and continues to register increasing profits.

But we have to add an important consideration about Philip Morris. It is one of the few companies (together with Altria, which is part of the same family of tobacco, or Glaxo, Lorillard and others) that regularly pays dividends every !101

3





Figure 22 - Performance of Philip Morris in the last 5 years

months. On the following page we illustrate the history of dividends paid by Philip Morris in recent years (Figure 23). At this time Philip Morris is paying dividends of $ 0.85 every 3 months, it means $ 3.4 per year. If we divide this by the share price ($ 93.32), we obtain the dividend yield which to date is 3.64% gross.

This means that after tax it is around 2.5%, not much ... The increase in the price of the last few years is leading to a reduction in convenience for investors who are now starting to buy Philip Morris shares, whereas the investors who had bought around $ 50 continue to have a return on dividend by a further 5% net, as well as a revaluation of the share price of 35% in a year, so a total of about 40%! Obviously the more you linger to purchase one stock with a similar pattern and the less you have the opportunity to earn. But under current conditions it is likely that Philip Morris will declare growing !102

dividend because most of earnings come back to the company itself though continuing to distribute dividends.

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Figure 23- History of the dividend paid by Philip Morris in the last 5 years

From the dividend history above you can see that dividends paid are increasing year by year and this reflects in the increase of the share price. In fact the stock paid $ 1.84 per share in 2008 while now it pays $ 3.4; this means that they have almost doubled, exactly the same thing that has happened to the stock price, so to maintain a stable dividend yield. This further reinforce the advice to hold a high-ROE stock in portfolio as much as possible during the years without selling it in the meanwhile, so that the dividend return on prices related to many years ago is importantly better than the recent price.

For example, for a Philip Morris investor having bought it in 2009 at 33 $ without ever selling it, the current dividend yield would be 3.4/33 = 10% a lot higher than the 3.6% for those buying Philip Morris at the current price.

The strategy of shares buyback is a policy that many companies carry on for maybe building an image to highlight to not belong to the majority of listed !103

companies seeking continuously new capital injections by the financial markets and entering new shares so obtaining liquidity for funding. So these companies will also mean that somehow they stand out from the crowd due to the fact not to ask markets new funding, but to be able to finance themselves with the profits of their business alone, indicating an above average capacity not to squander capital assets to no-return activities. In addition, there is also a matter of convenience in the case in which the company produces large gains and provide substantial dividends, since with the repurchase of shares the company itself reduces the base to be rewarded. When repurchases are made with the use of earnings we consider this self-practice absolutely desirable and to request to all companies to adopt it if the company has no chance to employ its earnings to enlarge the business in new fields and the current business is stable enough and does not require further investments, but when the repurchase of shares is done by asking money to banks or placing bonds at low interest, then we believe it is a mechanism of dubious value. In practice, the company asks for loans to banks or issues bonds and invests everything received for a shares repurchase; if the bank asks the 3% interest and the dividend yield is 5%, the company earns a 2%, but we do not approve this artifice, we rather believe that the company should buy back shares or not dilute the capital however, but only at the condition that its profits permit this.

We found a case of demand for placement of bonds to buy back shares for example in Lorillard which has increased debt of $ 500 million (at 2.3% interest) just to buy $ 500 million of its own shares (Offering $ 6 dividend per share which today price ate $ 115, i.e. 5.2% interest) (shown in Figure 24 you find the two news delayed of just 5 days!).

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Figure 24 – Lorillard news about bond placement and shares repurchase

We should also add, however, that the investment in a stock of the type of Philip Morris, that is which operates in the field of tobacco, exposes the investor to possible criticism from outside observers. Think about what would happen if Warren Buffett should start investing in a company like this: the reputation it has struggled to build for more than 60 years of career would likely be undermined by public opinion, which would accuse him of financing a sort of "Industry of Death" . We would like therefore to clarify that the judgment which we give of Philip Morris in our work is applicable only to financial data that this company offers, and not to moral considerations that we leave to the feeling of the individual investor.

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The case of Negative Equity

In the great majority of cases, our system is valid. There is one exception, those companies that have a negative equity and therefore a negative ROE. Since in the calculation of ROE, the Equity is placed in the denominator, it means that the longer a company has a negative equity and the more ROE tends to 0 with negative values, a result that leads us to a contradiction, because from what we have seen in previous chapters, a company with a reduced equity leads to high values of ROE, because it is able to return profits without using a large capital. This should be much more valid if the equity is negative. We therefore need to make a correction for this cases, without complicating things too much and make it unmanageable.

A company can end up with negative equity for two reasons: •

•

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a prolonged series of years closed with negative net income; losses are carried in the balance sheet and are subtracted by the initial equity to get the new available equity. So this may lead to record negative equity, especially if the company has failed to carry out capital increases in the meantime with the placing on the market of new shares consistent repurchases of shares by management at a higher price than what they had when they were originally released on the stock markets.

With our system, the first case is ruled out, since from the outset we exclude companies with a negative sum (and thus an average) of profits over the last 10 years. It remains the second case which happens usually for a small fraction of the shares available on the markets (roughly less than 1% of the total).

Take for example the case of Lorillard, again a company that manufactures and sells cigarettes. We observe in Figure 25 the evolution of the equity in the last 5 years.

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Figure 25 - Evolution of the Lorillard Equity in recent years

You can see how the equity is steadily dropped over the years up to the present value of -1,777 million $. Since the Lorillard 10-year average net profit is $ 905 million, this leads to a negative ROE of -50.9%, which would bring our index to a negative value and then in the last positions in our ranking, and then would be a contradiction.

Let us now try to understand what is the reason of this reduction of equity and we can only do it by consulting the balance sheet (Figure 26).

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Figure 26 - Equity Section of the Lorillard Balance Sheet

As said in the previous chapter, the reduction of equity is due to the repurchase of shares, removing them from the market. In the financial statements of Lorillard they are called as Treasury stocks, but they are no

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other than Lorillard shares repurchased from the market. It is exactly what is happening to Philip Morris, but still led to the extreme.

Although a part of the purchase was made by increasing the debt to $ 3.1 billion since 2008, and which includes the $ 500 million we talked about in the previous chapter, we see that Lorillard has bought back shares in the last two years for a total of $ 4.2 billion, so at least more than 1 billion $ of share repurchases has been achieved using net profit. And however, Lorillard showed a net profit in the last two years around one billion dollars and therefore it would be able to repay all the debt that has accumulated in just more than two financial years.

This said, let us see how we can "fix" our system to include this case. We have seen that the method of calculating ROE works fine for "normal" values of it.

It begins to creak when ROE begins to approach 100%. We need a mathematical function to apply to equity before calculating the ratio that brings us to the ROE. So a function that tends to 0 when Equity becomes 
 infinitely negative, so as to bring the ROE to infinite values to the limit and a function that for positive equity leaves it unchanged. For negative values one can use an exponential function appropriately calibrated (seen that we speak of billions of dollars the base b of the exponent must be very low, for example 10-12), a function that is done as in Figure 27. For positive values instead we need an invariant function (y = x for instance). In a certain around we would then need that the two curves meet to be able to apply the one for negative values and the other for positive values of the equity. This is the maximum complication of mathematics which is necessary with our model.

We have tried to implement an index made in this way, but we came up against the limitations of normal processing computers. You start talking about exponential functions of billion values and in our tests we were not able to overcome the limitation of the maximum precision made available by a normal computer.

We therefore decided to invent a shortcut to not blow our system because of this limited cases. The solution we propose is a linear approximation of what we would need by applying a function of the type shown in Figure 28, which we hope will find you agree.

In this way the calculation of the ROE would not suffer any impact for an equity higher than Elimit, while it would follow the linear approximation on the left for negative values or under the Elimit value of equity. Using a b = 20 times the 10-year average earnings we have covered up to the event that a company should record an equity negative 20 times their average earnings recorded in a !109

year, a really remote event, since the company would earn for 20 years and do nothing but buy back its own shares! On the other hand, in the case of equity=0, the function would return the value of the 10-year average earnings, thus bringing the ROE to 100%. It goes without saying that, therefore, the 


y=bx y=x

Figure 27 - An example of an exponential function and invariant one

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y=x/a + b -b=20*Earnings

a=Earnings

x

d Elimite

Equity

Figure 28 - Our proposal to treat equity lower than 10-year average earnings

best value of Elimit to be used may be equal to the value of profits, so that if using the classical way of calculating the ROE we obtain values less than 100% then we can continue to apply no adjustment function, while if the values obtained are higher than 100% or negative we use the approximation on the left that allows us to extend the validity of our model. There would be a mismatch for values x of equity between 0 and profits, because in that case we would apply the approximation function and we would have a difference of d compared to the traditional way, but we believe that this error is indeed negligible. 


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About Sales

At the presentation of quarterly results often can be seen that reactions of the market on a particular stock are not so related to the values of net profit, rather to those of turnover (or Sales - usually financial media adopt the term of “top line” for sales and “bottom line” for net profits, due to their arrangement in the income statement).

This is especially true for companies that are at a loss for years: turnover can allow us to figure out if something is changing in the business of the company. That is, if the turnover is growing, sooner or later this could translate in an increase in net income and hence in all the benefits for the shareholder we have already spoken about.

Here we want to find a right relationship also between the price of a share and the sales data of the underlying company.

In general, for the most profitable companies it is observed that the net profit is equal to a percentage ranging from 5% to 10% of turnover. But it is not uncommon to find cases where this percentage also touches 20%, as for example in the case of Western Union.

Calling SPS (Sales Per Share) the turnover attributable to each share obtained by dividing sales by the number of shares outstanding, we can write: EPS = j * SPS !113

Where "j" is the percentage of sales (top line) that are transformed in net income (bottom line).

At the beginning of the book we had found the formula that links the price of a share to the EPS and the interest rate in the case of pay-out ratio of 50%, which is the following: P = ½ * (EPS/i) Putting together the two previous formulas we can deduce the relationship between the price and the SPS in the following way (simply by replacing j * SPS to the EPS): P = ½ * (EPS/i) = ½ * (j*SPS/i) = ½ * (j/i) * SPS i.e.: P/SPS = ½ * (j/i) Calculating the ½ * (j/i) value for different combinations of interest rates (i) and percentage of translation of net turnover into earnings (j), we get the following table for the correct values of P/SPS, which in financial jargon is simply called P/S (Price on Sales):

! !114

The table shows us that in “normal” conditions, i.e. for example with interest rates at 3% and profits equal to 6% of sales, the price of a share should be approximately equal to the value of the sales per share.

Finally, by multiplying both members per the number of shares of the previous formula, we get another interesting formula: P = ½ * (j/i) * SPS

→

P*Shares = ½ * (j/i) * SPS*Shares

But P*Shares is nothing else than the market capitalization of the company, because we multiply the stock price by the number of outstanding shares, while the SPS*Shares is nothing else than revenue, since the SPS was obtained by dividing the revenue by the number of shares and now we are multiplying again by the number of shares. Then: Capitalization = ½ * (j/i) * Sales So, in normal conditions, the capitalization of a company should be roughly equal to the amount of revenue that it produces in a year.

This information is particularly useful because it allows us to immediately identify those sensational cases of overvalued or undervalued companies.

For example, in October 2013, J.C. Penney was found to have a market capitalization of approximately $ 1.5 billion compared to a turnover of more than $ 10 billion. So the capitalization was approximately 0.15 times the sales, while for a fairer price it would have been at a value approximately equal to the turnover. We were therefore faced with a highly undervalued stock, further highlighted by the very low value of the P/E at 10-year average of approximately 3.

Important also is the fact that with this additional tool we are able to evaluate those companies that are at a loss for years and which we would discard with our system, because the P/E would not have sense because it would be negative, but the P/S would instead be meaningful because the turnover obviously cannot be negative. !115

However, we decided not to include also the P/S in the formula of our global index because we believe that the P/E is more effective in determining the extent of the undervaluation of the company on the basis of what it is actually capable to return to shareholders, as the turnover, although a useful measure, must be translated by the company to a significant profit. A company that produces a good turnover but is unable to reduce costs to translate it into profits and then return for the shareholder is discarded by our system, rightly we believe.

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A “qualitative” integration to our system

So far our method has been mainly quantitative, almost entirely based on financial data and financial statements. Along with these data it is better to gather some information on the company itself. A minimal analysis of the business is essential for a long-term perspective. If you look at the list of companies that Buffett bought you will not find many of those found in the first positions of our index. This because Buffett is more oriented towards companies with a big brand that can guarantee him a long-term horizon, instead of undervalued companies in the immediate. In this sense, it has become increasingly linked to the Philip Fisher’s theory of analysis of companies. The Fisher’s method explained in his book "Common Stocks and Uncommon Profits" is of great importance to him, that is trying to collect as much relevant information about the company which can provide guidance on its future sustainability. In most cases this analysis ends with the investment in the most important brands in the world, although not available at a discount price as Coca-Cola, Procter & Gamble, Kraft, Sanofi Aventis, American Express, Johnson & Johnson. Early in his career, Buffett declared that his way of investing was 80% Graham and 20% Fisher, but a good part of the financial experts are ready to bet that if they did the same question today he would not hesitate to reverse percentages.

In our case the main activity to be performed will be an analysis of the companies in the first positions of our ranking and, in the case the proposed stocks were the best well known multinational companies, large and with a !117

strong brand (as usually happens with our investment system) invest in them without delay, and only in the event that our system should propose stocks of little-known companies, small and for which we're not sure of the future business, find out about other not financial aspects of the business. All possible information is good to try to understand whether it is worth, however, investing in it or not.

This behavior is undoubtedly of vital importance if you want to buy only stocks with a very low P/E to obtain yields out of the ordinary, regardless of the ROE or value of capitalization. Considering only the lower P/Es we would certainly find less known companies than those with high ROE and on them we will need to ask whether they have serious liquidity problems that could lead to insolvency and to be unable to finance themselves properly.

This step is not obviously to be outlined, every stock will be analyzed on its own, gathering as much information about it to be able to finally make a decision if to invest in it or not.

As mentioned in the analysis of the Philip Morris case, an investor may have imposed to himself or herself as a principle not to invest in any circumstances in companies that do not operate in business considered ethical. So, if an investor does not want to absolutely finance the tobacco companies he or she will inevitably have to forego some of the companies in the highest positions in our rankings, namely: Philip Morris, Altria Group, Lorillard and British American Tobacco.

Similarly an investor may have imposed to himself or herself for any reason not to invest in pharmaceutical companies and thus avoid to buy stocks such as GlaxoSmithKline, AstraZeneca and Eli Lilly, and so on.

However, if an investor adopts a strategy of pure cynicism, considering only the financial convenience, the ranking relative to our index at the time tells us that the tobacco companies are some of the most convenient.

Other qualitative considerations may relate to the sector in which a company operates. For example, from the data of P/Es we were able to calculate, we see an overall depreciation of the companies operating in the oil sector.

Companies such as Repsol, Lukoil, BP, Total and Eni are selling with a P/E between 7 and 9, so quite low, as if to indicate a general skepticism about oil companies to be sustainable. However, other companies such as Chevron (P/ E of 15) or Exxon (P/E of 16) are already traveling to more normal P/E values, but never overestimated. So an investor may show a general skepticism towards some economic sectors in which to invest and thus avoid even the !118

most convenient companies in the sector whose shares are trading at an affordable price.

Another case of this kind applies to those companies operating in the defense industry, for example Lockheed Martin. This stock sell at a moderate P/E probably because investors do not believe that States will continue to invest on military forces, due to the persistent economic crisis and the low opinion common people has regarding this kind of public expenses.

So the choice of the stocks in which to invest should be based for example on the strength of the brand. An investor who wants to play it safe, for example, will avoid investing in a little known stock such as ITT Educational Services, although it is in the first position of our final ranking, but rather will focus on a strong-brand stock and known all over the world such as Western Union, which is always in the top positions of our ranking, has a very high ROE and a low P/E of 10. When you invest in little known companies and with a questionable brand, the risk of running into bad investments due to not known information on the company itself increases. Similarly Western Union is preferable from a qualitative point of view to the tobacco companies or Lockheed Martin, as the latter operate in businesses seen in a bad light by a large part of public opinion. Unless sending money around the world has become unethical too! This is to say that the boundary that separates the ethics and not is not always so identifiable and clear.

From what has been said it should be clear that the price at which a stock is selling is in part due to the current financial results and in part to the future perspective of the business. This explains also why Google, Amazon, LinkedIn or Facebook sell at very high P/E, i.e. not mainly for the gain they are able to guarantee now, but for those they could be able to offer in the long term. To be honest, we must admit that our system is not able to identify those stocks that will be able in the future to declare net incomes completely different and hugely higher than those they have declared in the past. But probably only a system which is able to predict the future can be able to do this. For example our system would not have been able to predict that while Google declared a net income of 100 million $ in 2002, it would have declared a net income of 10 billion $ in 2012! Or that while Apple declared a net income of 65 million $ in 2002, it would have declared a net income of 42 billion $ in 2012! For this sensational cases you need another system than ours, sorry.

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About currency

We said at the beginning of the book that the investor in stocks should adopt a general openness to markets around the world and not limit himself or herself to stocks listed on the national stock markets.

This brings us to invest in stocks listed in currencies other than that of our bank account. The course of trade between currencies therefore affect the final performance in equities.

The shares of a company may in fact be listed on multiple stock markets of different countries, for example 60% of the total shares of a company may be in the hands of institutional investors and therefore not traded on the stock markets, 20% of the total shares may be floating (passed from the hands of an investor to another) and traded on the New York Stock Exchange (NYSE), another 10% of the total shares may be floating on the London Stock Exchange (LSE) and another 10% of the total shares could be floated to Euro-TLX market. There would be therefore shares of the company traded on the stock markets with three different currencies: U.S. Dollar, British Pound and Euro.

That said, the effect of currency can arise in at least two cases that we are going to show.

The first case occurs when we buy a share in a particular currency (e.g. â‚Ź), which is traded on another market in another currency (e.g. $). Since the value of one share must be identical in all markets, whether from one day to another the dollar should strengthen against the euro, the investor in euro would register an additional gain due to the fact that the stock is yes worth the same dollars, but the dollar is worth more euros and thus for the transitive property !121

that the stock is worth more â‚Ź! Conversely, if the dollar were to weaken, the investor in euro would experience a decrease in the share price not related to the course of the stock itself but only to the change in the exchange rate between the two currencies.

The second case, much like the first for the truth, is when you buy shares in a market with a currency other than that of your bank account. For example, from a euro account you open a position on a stock listed on the NYSE. In the latter case, the equivalent in euro of its position on the stock is automatically converted from dollars to euros by bank systems according to the latest exchange rates between currencies available. So if the dollar were to strengthen over the euro it would result in an additional return and vice versa.

So as a further advice, you should seek equity investments in those markets whose currencies you think will reevaluate over the years with respect to the one used in your bank account. However, we believe that this type of analysis is not suitable for the average investor to whom also is directed primarily our book. We believe it is important only to acquaint the reader only of the existence of this factor on the determination of the final returns while investing in stocks.

If you ever need to know the exchange rate between two currencies, you can consult various Internet sites that offer such services. One of these is for example www.xe.com

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Advantages of stocks when compared to funds

Investing in stocks allows you to know exactly what you are buying, that is, participation in the capital of a company listed; on the contrary, investing in a fund does not provide you the full knowledge of what you are buying. If you do not want to do better or worse than the market, you can invest in a fund based on an index, a fund that is invested on the same stocks of which an equity index (e.g. Dow Jones index) is made . Selecting your stock portfolio, on the other hand, allows you to build your own unique financial instrument, knowing the exact stocks of which it is composed. In the vast majority of cases, the funds show in the privacy statement a description of the elements of which it is composed, probably they may include some instruments that you approve, but others which you do not like. But you cannot decide, you have to buy the whole package.

Buying individual stocks, you can invest only in the stocks that you think will beat the average market in terms of future performance relatively to the time horizon you have chosen.

A further important and fundamental advantage of stocks is that, depending on the stock considered, some pay dividends and therefore their rate of return is based not only on their day by day price, but also on the regular payment of dividends. Funds, instead, do not always pay dividends coming from the stocks !123

composing it, so you have to be careful about this and try to understand in the information notes if the fund pays dividends or not.

With regard to the stock dividends, when applicable, they are paid without the investor has anything to do, they are automatically delivered to the account associated with the deposit of securities.

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What stocks to begin to analyze

At this point we can define complete our fundamental investment system. We just have to apply it!

You may ask, and now where do I start?!

Our advice is to begin to analyze one by one the largest companies in the world; analyzing the stocks is a job that requires a lot of time even if you have a good investment system in your hands, such as the one presented so far.

Data should be collected, put them together, ratios have to be calculated and compared with those of alternative stocks, and so on. The writer, after years of analysis of financial statements and application of the investment system presented here, is unable to complete the analysis of a key stock in less than a quarter of hour. Whereas the stocks listed on the markets are tens of thousands, no one person can analyze all the stocks in the world!

It is necessary to make a selection.

There are several ways to choose which stocks to begin to analyze, for example, in order of importance: •

•

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search on the search engines the lists of global companies with the highest capitalization and begin to analyze them one by one, as the cap is one of the multiplicative factors of our index, analyzing first companies with large caps will take you first to identify the best stocks available according to our system; analyze the stocks most often on the lips of investors (Facebook, Apple, Google, etc.) for which you are curious to finally understand if it is a good investment or not and to silence all voices that are

•

served up by the media. Another source of companies to analyze is to evaluate the most active of the day, for example taking a look to financial channels such as Bloomberg TV (www.bloomberg.com/tv) which is also an excellent instrument of economic information in general. scroll one by one the stocks that make up the most important indices of stock markets worldwide, then in this order: Dow Jones, NYSE, Nasdaq, LSE, Dax30, CAC40, Euro-TLX. Only analyzing all these indexes requires the work of a whole year of analysis!

The last point, therefore, we believe is more for specialists.

Let us detail only the first step. If we search for the results of a search engine on the key "most capitalized company world" we are directed to a Wikipedia page that offers us the following lists of companies with the highest market capitalization in the world, one by Yahoo Finance and the other by the Financial Times (fig. 29 and 30):

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Figure 29 - List of companies with the highest capitalization according to Yahoo Finance

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Figure 30 - List of companies with the highest capitalization according to The Financial Times

From these lists, there is plenty of material to start with your analysis. As you can see they are mostly American companies.

If you want to start directly from the stocks that make up an index, such as the Dow Jones, you can simply browse the site of the market, in our case www.dowjones.com and click on the DJIA link (Dow Jones Industrial Average) as in Figure 31.

Once you click on the index you access the next page with a summary of the performance of the index and a list of the stocks of the index (Figure 32), which you can arrange to analyze one by one, since they are probably the most important and historical stocks in the world.

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Figure 31 - Link to the list of components in the Dow Jones

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Figure 32 - Link to the list of components in the Dow Jones !128

Step by step analysis of a stock

Taking a cue from the list of stocks with the highest market capitalization in the world, we see that, for example, we do not have any analysis of the way Google is worth. So we try to find the information we need to determine if Google is a stock in which it is worth investing or not.

Let us start first accessing the site www.google.com looking for the section "Investor Relations". Once you have accessed the famous page of the search engine you have to follow the link at the bottom right "About Google" which is the section that provides information about the company itself (Figure 33).

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Figure 33 - Link to "About Google" with the company information

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You are directed to the page shown in Figure 34, where you should select the link "Financial Information" in the Investor Relations section.

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Figure 34 - Link to "financial information"

You are then directed to the page in Figure 35 in which it is necessary to follow the link "SEC Filings Archive" and later the year 2012 which is the last one for which we can find an annual report.

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Figure 35 - Link to the "SEC Filings Archive" section

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Then, following the link to 2012 SEC Filings, we access the page shown in Figure 36, where the first line is actually the annual report in both html and pdf format and that is just what we need.

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Figure 36 - Access to Google's annual report for the year 2012

We personally prefer the html report because it runs faster and takes you directly to the numbers we need. You open the scroll down until you find the point where you find tables of numbers that are the ones that interest us.

The Google’s annual report is very concise and straightforward and therefore it leads very easily to the table that we need which is the first right after those relating to the price of Google stock. The table which interests us is shown in Figure 37.

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Figure 37 - Summary of key Google financial data in the last 5 years

From the table we obtain that the net profits (net income) for the last five years are as follows: 2012: 10,737 mln $ i.e.: 10,737,000,000 $ 2011: 9,737 mln $ 2010: 8,505 mln $ 2009: 6,520 mln $ 2008: 4,227 mln $ In addition we can pick another fundamental figure for our analysis which is the "Total Stockholder Equity" amounting to $ 71,715 million.

We need to find another essential figure, which is the total number of outstanding Google shares, without which we are unable to calculate earnings per share (EPS) and then the P/E. Unfortunately, Google shares are divided into two types called class A and class B; class B acts as the option to purchase the shares of class A, you cannot tell if the B shares are listed as normal shares. Looking on Yahoo Finance we did not find a record of this stock B, then we deduce that they are not listed. At this point, to simplify matters we use the data that is given in the table in figure 36, last year “earnings per share� to calculate back the number of shares outstanding. Then: Number of outstanding Google shares = 2012 Net earnings / 2012 net earnings per share = 10,737 mln $ / 32.31 $ = 332,311,977 shares We used the net income per diluted share to consider the worst case that any right to convert other financial instruments into shares is exercised. Useless to dwell on this point by experts, it does not change much when you consider either the diluted earnings or not.

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At this point we have obtained all the information that we expected from the 2012 Google annual report. The net profits of the five years prior to 2008 now remain to obtain. From the page in Figure 35 then follow the link for 2007, and again following the link to the 2007 annual financial statements, always browsing the account as done for 2012, we come to the table in figure 38.

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Figure 38 - Summary of key Google financial data for the years 2003-2007

From the table we extract the remaining data of net income that we were missing: 2007: 4,203,720 $ 2006: 3,077,000 $ 2005: 1,465,000 $ 2004: 399,119 $ 2003: 105,648 $ We can now also close the 2007 report and the Google site too, we do not need other data for our analysis.

Adding up all the gains of the last 10 years and dividing them by 10, we get the 10-year average earnings that is: (1) Google 10-year average earnings = 4,462 mln $ (2) Number of outstanding Google shares = 332,331,977 (3) 10-year average earnings per share (EPS) = (1) / (2) = 13.43 $ per share (4) Last Google share price = 880.23 $ (5) Google P/E calculated with 10-year average = (4) / (3) = 65.54 (6) Google Equity = 71,715 mln $ (7) Google ROE = (1) / (6) = 6.22 % !133

(8) (9) (10) (11)

Google Capitalization = (2) * (4) = 292,504 mln $ Dividend per share = 0$ Dividend yield = 0% Investment Index = [(7) 3 / (5) 2 ] * √ (8) * (1+(10)) 4 = 0.03

Therefore, from the above data what our opinion about the Google stock should be? Obviously NEGATIVE! The stock has a low ROE (so the prospect to return only 6% yearly in the long term), has a high P/E that is three times the threshold of 20 that we set and is therefore strongly overvalued by the market, and then the final index (0.03) is very low if compared to that of the best stock identified (5655 of ITT Educational Services) and hugely less than the value of 1 which is the minimum value to accept the investment. Moreover the company does not even pay dividends.

Google is the classic example of "fashionable" stock which is overvalued by investors, and does not have an attractive return in perspective. Quite the contrary, we believe it is one of the dangerous stocks in the event that the current fashion should pass and the company were to suddenly begin to record a reduction of its business volume for any unpredictable reason to date.

All analyses that you can perform over stocks will not differ greatly from that shown above. The reader is now able to operate almost autonomously and in his or her personal stocks evaluation.

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How to evaluate IPOs (Initial Public Offerings) – The Facebook case

IPOs (Initial Public Offerings) are the initial placement of shares of a company in one or more markets. The difficulty of assessing these stocks by the unaware investor stem mainly from the fact that there is not a history of past prices with which to compare the initial price offered by financial brokers who are in charge of placing the stock in the markets. But with our investment system, these cases do not have anything different than the valuation of the already listed shares. For the latter, our assessment is intended to give an opinion about the current stock price, that is, if the current price is overvalued or undervalued. In the case of IPOs, valuations will be given to pronounce judgment on the initial price that is offered to us. Let us apply our system to the most talked-about IPO in 2012: Facebook.

As is now clear, by the majority of investors, the initial price of Facebook ($ 38) is deemed to have been made at a price too high to be "honest." And in fact, in the months following the placement, Facebook stock price has dropped down to $ 20. Obviously the owners of the company are interested in proposing the highest possible price for the placing, since the value of the shares placed is received by the company in the form of cash. So the company tries to maximize its own benefit ... at the expense of the unfortunate investors who have subscribed the initial public offering, unfortunately. So companies generally try to quote in the Stock Exchanges immediately after presenting the best annual report possible, so as to encourage investors to evaluate the company only on the basis of the results of the last year. Maybe they will also exclude the worst balance sheet items from the last account in !135

order to postpone the period in which they must be registered thus reducing the net income, to present the highest possible pre-IPO net income. But thanks to our key concept of the 10-year average earnings, we can overcome also this attempt.

Let us see how we can give a fair price to Facebook applying step by step our system.

Obviously we begin to recover all possible Facebook annual reports by going to the Investor Relations page by searching on Google with the keywords "Facebook Investor Relations". We access to investor.fb.com, immediately following the link "SEC Filings". We access the last 10-K annual report.

Within this document we find data about the accounts of the previous years, there are only those that span from 2008 to 2012 (Figure 39). As we suspected, the year previous the IPO, presents the best ever net profit.

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Figure 39 – Summary of key Facebook financial data for the years 2008-2012

So we consider equal to 0 profits for the years prior to 2008 and so we get a sum of the net profits from 2008 to 2012 of $ 1,138.5 million which, divided by 10 years is $ 113.85 million a year average earnings, as you can see very less than $ 668 million presented for the year before the IPO. Now we need two figures of information i.e. the equity and the number of shares outstanding.

Equity is $ 11.755 million, while outstanding shares turn out to be 2,166 million, i.e. 2.1 billion.

So it is an EPS = 113.85/2166 = $ 0.052 per share which, multiplied by 20 make a fair price of $ 1.05, compared to $ 27 at which Facebook is exchanging !136

in these days or more importantly to the 38$ of the IPO. The ROE is instead equal to 113.85/11755 = 0.97%, one of the lowest values that can be found among our rankings.

If, instead, we would be less conservative, considering only a 5-year average instead than the 10-year one, we would get an EPS of 227.7/2166 = $ 0.105 per share which, multiplied by 20 make a fair price of $ 2.10, still greatly below than the current price of $ 27. ROE would instead be equal to 227.7/11755 = 1.94%, still very low.

So in each case the evaluation of Facebook during the IPO and also its current price are really exaggerated. Facebook would be probably a bargain only at less than 1 $.

The same reasoning apply even more dramatically to LinkedIn which results to have a P/E of 3500 on the 5-year average! A value of price equal to 3500 times the profits that a company produces in a year, means that the company should survive for 3 and a half millennia (3500 years) declaring every year average earnings it stated in the previous 10 years! Do we realize how risky is to invest our money in such a stock? So, as said at the beginning of the book, a stock should not be bought at any price, even if the underlying company is the best company in the world, but only at a reasonable price or at least right with respect to the underlying financial data.

A good number of IPOs are comparable to the Facebook case. We are talking in particular of those stocks operating in emerging sectors, for example renewable energy. In the last years we have been flooded by a number of invaluable stocks of companies affirming to gather capitals to work in the field of renewable energies; but they had not a started business, nor assets, so they were asking for capitals without having anything in their hands. After some years we can say that a good number of these stocks turned out to be a cheat.

In particular, when a company does not make a good use of the cash raised from the placement of the stocks, it is inevitable to not expect big returns from the stocks of that company. The company must consume money only in those activities that can generate a return; for instance, from some Internet articles we found that Facebook is one of the best companies to work: for example, if you need a faster pc for your work no expense is spared: simple, with money provided by investors! So we believe that the gives a measure of the waste of money made by the company: the lower the ROE and more likely the company is wasting capital, and thus that it will not be able to generate a return on the stock. The best companies to invest in are those that are very !137

careful on expenses, directing them only where they can be productive and generate a return in the future.

Many financial experts justify the price of Facebook basing on the fact that about 2 billion users around the world use the platform. This we believe, however, that is not sufficient, because what counts are the profits it can produce with a similar number of users. How many Facebook users would abandon the site if only from time to time its use should be subject to the payment of a fee? Probably the most, and not forget that we are talking about in the end only of a website, which is assessed about 60 billion dollars!

With regard to the IPO, finally we add that we believe worthwhile investing in stocks with a story behind them, because they have already demonstrated or not to generate a return and to be fruitful or not the money obtained with the IPO. For a newly floated company you cannot figure out if the money is made fruitful by the company itself. For example, Facebook has raised $ 80 billion from the IPO, but remained with the same pre-IPO business. So where is this money? Was it invested in productive activities, in advantageous acquisitions, in new market segments? Or are they still in the form of cash and unused?

Only time can answer these questions, and the 10-year average earnings allows us to avoid such investments.

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Development of a software for our investment system

From the analysis performed in the previous chapter it will be appreciated that to manage manually amount of relevant data for a certain number of stocks can be difficult if not impossible. At a time when the number of stocks under control grows beyond a certain amount it will be necessary to adopt the support of a computerized tool. You can choose the tool that best suits you, however here we try to provide our proposal.

You could use a spreadsheet to store data on financial figures and prices and make the calculations, or you could develop software independently possessing the appropriate knowledge.

The solution that we have adopted is the latter and consists of a web page from a web hosting with a supporting database for storing all the information.

The information in the database is accessed dynamically from a scripting language (e.g. PHP with SQL queries) and presented on a web page in the form of rankings. The site does not care much about the shape, what interests us is to keep our rankings updated automatically with an automatic update of stock prices to immediately seize opportunities that arise on valid companies who have seen lower its price in the last period. The result is presented in Figure 40.

The first step must be to create the tables in the database to store the information needed to create a ranking automatically: • !139

a table of companies with information such as name, ISIN, currency, dividend per share of the last year

• • • • •

a table to store net earnings year by year a table to store equity values year by year a table to store stock prices day by day a table to store the numbers of share outstanding year by year a table to store exchange prices between currencies

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F i g u r e 4 0 - E x a m p l e o f a we b p a g e t o m o n i t o r s t o ck r a n k i n g s (www.theawareinvestor.com)

Once you have created the database, web pages that allow a minimum interaction must be developed, for example: • • •

• •

Insert a stock with its net earnings year by year, equity values, number of shares and price Automatically calculate the 10-year average earnings, the P/E, ROE, dividend yield and capitalization based on the data entered manually Automatically calculate our index, automatically ordering the stocks for this index, or only for P/E or just for ROE, dividend yield or capitalization Automatically update daily prices for all stocks entered and automatically rebuild indexes and rankings Automatically update the exchange rates between the currencies

Our system does all of these things and we were able to accomplish it without excessive use of time, it only takes some familiarity with a programming !140

language like PHP and a database query language like SQL and a little habit to design web pages. The tables found in the appendix have been created just through this software.

For example, a page for the insertion of the values of the gains or equity is made as in the mode illustrated in Figure 41.

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Figure 41 - Example of a web page to insert the values of profits and equity !141

The moment you enter a new value of earnings amount for a given year, the system automatically recalculates the new value of average earnings in 10 years, the ROE and P/E and recalculates the index and final positions in 4 different ranking factors: ROE, P/E, dividend yield and capitalization.

For example, a SQL query that is launched at the time of variation of one of the useful data: equity or number of shares is as follows: UPDATE companies A SET A.EQUITY = (SELECT B.AMOUNT FROM equities B WHERE A.ISIN = B.ISIN order by B.YEAR desc limit 1), A.EARNINGS = (SELECT AVG(C.AMOUNT) FROM earnings C WHERE C.ISIN = A.ISIN order by C.YEAR desc limit 0,10), A.SHARES = (SELECT D.AMOUNT FROM sharesoutstanding D WHERE D.ISIN = A.ISIN order

by D.YEAR desc limit 1);

With the above query the value of the equity of the company is set to the most recent, the average profit is calculated considering only the last 10 available, and the last value of the number of outstanding shares available is taken.

The values instead of P/E, capitalization, dividend yield and ROE for equity greater than the average profit is calculated with the following query: UPDATE companies A SET A.PE = (A.PRICE/(A.EARNINGS/A.SHARES)), A.CAP = (A.PRICE * A.SHARES), A.ROE = (A.EARNINGS/A.EQUITY), A.DY = (A.DIVIDEND/A.PRICE) WHERE A.EARNINGS/A.EQUITY <= 1

The cases instead of negative equity or otherwise lower than average earnings are treated with the following query that applies the transformation function discussed in the chapter on the case of negative equity: UPDATE companies A SET A.PE = (A.PRICE/(A.EARNINGS/A.SHARES)), A.CAP = (A.PRICE * A.SHARES), A.ROE = (A.EARNINGS/((A.EQUITY/ (5*A.EARNINGS))+A.EARNINGS)), A.DY = (A.DIVIDEND/A.PRICE) WHERE A.EARNINGS/A.EQUITY > 1 OR A.EQUITY <= 0

In our query we applied a parameter b equal to 5 instead of 20, so we are able to treat up to cases in which the equity is negative up to 5 times the average profit, but this is a limitation that so far has never created problems. !142

The calculation of market capitalization must also take account of exchange between currencies, and this is done by accessing the data in the table of currencies: UPDATE companies A SET A.CAP = A.CAP * (SELECT B.EXCHANGE_ON_DOLLAR FROM exchanges B WHERE B.CURRENCY = A.CURRENCY)

Finally here is calculated the global index which is what we use to draw our main ranking: UPDATE companies A SET A.AII = (POWER(A.ROE,3)/POWER(A.PE,2)) * POWER(A.CAP,1/2) * POWER((1+DY), 4)

As you can see it is not more than the application of our proposed formula in the chapter on the creation of an index to classify stocks.

The last step is to create by ourselves the values for the different positions in the standings, after we created a table of the main copy for convenience. The position of a stock is calculated by counting how many other companies have a better index than that we are considering, as in the following way: UPDATE companies A SET A.AII_POS = (SELECT COUNT(*) FROM companiesCopy B WHERE B.AII>A.AII and B.ENABLED='Y') + 1, A.PE_POS = (SELECT COUNT(*) FROM companiesCopy C WHERE C.PE<A.PE and C.ENABLED='Y') + 1, A.ROE_POS = (SELECT COUNT(*) FROM companiesCopy D WHERE D.ROE>A.ROE and D.ENABLED='Y') + 1, A.CAP_POS = (SELECT COUNT(*) FROM companiesCopy E WHERE E.CAP>A.CAP and E.ENABLED='Y') + 1, A.DY_POS = (SELECT COUNT(*) FROM companiesCopy F WHERE F.DY>A.DY and F.ENABLED='Y') + 1

With an application of this type we get the result that we always store in a database our balance sheet data and not risk losing them, not having to do any calculations - which is instead performed automatically by the system - and not having manually to retrieve stock prices. Certainly the work of analysis of financial statements and also the burden of entering data on a site remain, but these operations must be carried out only once a year for each stock. However the fact of being able to automatically change the prices is a huge time saver, and prices are at the end the only data that changes from day to day and that !143

may cause changes in the rankings in the short term. The balance sheet data once entered remain valid for the whole year and not cause changes in the rankings very frequently.

To automatically update prices we need to access web pages of other websites that track the movements of the various stocks in the world. Once you choose a site that offers these services (there are many on the Internet) you need to create a php code that opens a connection to the site identified, for example via the "curl".

The piece of program that we have developed is as follows: mysql_select_db($database_Conn, $Conn); $query_PriceUrls = sprintf("SELECT ISIN, ID_PRICE, CURRENCY FROM companies"); $QueryPriceUrls = mysql_query($query_PriceUrls, $Conn) or die(mysql_error()); while($res=mysql_fetch_row($QueryPriceUrls)){ $ch = curl_init(); curl_setopt($ch, CURLOPT_URL, "http://www.xxxxx.com/id=". $res[1]); curl_setopt($ch, CURLOPT_HEADER, 0); curl_setopt($ch, CURLOPT_RETURNTRANSFER,1); curl_setopt($ch, CURLOPT_USERAGENT, "Mozilla/5.0 (Windows; U; Windows NT 6.0; fr; rv:1.9.1b1) Gecko/20081007 Firefox/3.1b1"); $body = curl_exec($ch); $body_use=strstr(strstr($body, "yfs_l84"), "</span>", true); $price=substr(strstr($body_use, ">"),1); $price = str_replace(',', '', $price); if ($res[2]=='ÂŁ'){$price_num = GetSQLValueString($price, "double")/100;} else {$price_num = GetSQLValueString($price, "double");} if ($price_num > 0) { $updateSQL = sprintf("INSERT INTO prices values('$res[0]',NOW(),$price_num)"); mysql_select_db($database_Conn, $Conn); $Result1 = mysql_query($updateSQL, $Conn); $updateSQL = sprintf("UPDATE companies SET PRICE=%s, PRICE_DATE=NOW() WHERE ISIN=%s", $price_num, GetSQLValueString($res[0], "text")); mysql_select_db($database_Conn, $Conn); $Result1 = mysql_query($updateSQL, $Conn); } } exec('php /updateIndexes.php');

The program performs the following tasks: !144

â&#x20AC;˘ â&#x20AC;˘

â&#x20AC;˘

queries the table of stocks and stores all codes for the research along with their currencies cycles on stocks under observation and performs the following steps: o establishes a connection to the external site passing the unique identifier of the stock o make a parsing of the html page back to our program, selecting only the price information o inserts the recovered price in the table, dividing by 100 for sterling prices which are expressed by the London Stock Exchange in pence at the end recalculates all indexes based on the stored current prices of all stocks that are in our database

Be careful however not to schedule a price update too frequently. Site administrators that provide data on prices may not appreciate. We recommend a weekly update, this is more than enough for your purpose.

We emphasize that this method is very useful for discovering stocks that are going to very low values of P/E and that are going to be suddenly undervalued by the market; but do not expect the rankings varying by the minute! Considerable differences with our method only occur at a distance of at least weeks, and this justifies even more its goodness as a method for longterm investments. Indeed, we add that the values of a company's ROE calculated using the 10-year average earnings rarely change even in the course of years, as it may change only for consistent change in average profits or equity. But a 10-year average change takes many years, as the company should begin to declare profits which are very different from those declared over the previous 10 years. With regard to the equity it changes year by year, but consistently only for those companies that make large capital increases or large share buybacks, given that the net income (which as mentioned is to increase the value of equity) typically takes values around only 10% of the equity total.

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Purchasing stocks on the Internet banking

To buy stocks it is not required to go to a bank office. With the Internet you can buy and sell stocks in full autonomy. You should first of all ask to your bank to enable your bank account to get online, also requiring the deposit of securities connected. They will provide the credentials for accessing the protected site of the bank to operate in securities.

The operations required to purchase stocks are as follows:

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Be sure that you are authorized to operate in the market in which the company is listed, usually banks allow you to work for free (paying only the fees for the purchase and sale which are usually around the 0.20%) on some national markets, such as the S&P MIB or EURO TLX. To operate on foreign markets such as the Dow Jones, NYSE or Dax, some banks charge a monthly fee of around € 10, each bank will offer a set of markets to operate on, obviously not all the world's markets. In our opinion you should at least be able to operate on Dow Jones, NYSE, Dax, Euro TLX and S&P MIB;

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Search for the stock using the web site advanced search by entering the stock name as a search key or the ISIN;

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Check the list of results with the list of markets in which the company is trading and choose which to buy considering the currency of the market;

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Enter a purchase order by entering the number of shares to be purchased and the maximum price that you are willing to buy, the site will purchase up to the number of shares that are covered by the liquidity in the bank account;

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Once you have placed the order, some banks may require you to enter a PIN to verify the identity of the purchaser;

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Check your purchase showing the overall status of the portfolio. For completion of the purchase you will find that the liquidity available on the account was decreased by the value of shares purchased based on the purchase price and commissions.

In case you instead want to sell a stock, you must start from the global view of tour portfolio and select "Negotiate" (or similar) next to the stock that you want to sell. You must enter the quantity to sell and the minimum price limit at which you are willing to sell.

Placing an order to buy or sell does not mean that you have actually bought or sold shares, but it only means you have entered the request order which has been put into the stock market in question. The order will actually be a purchase or sale of shares on the market only if orders are received by corresponding opposites with compatible prices. For example, a purchase order for 1,000 shares at € 2.3 effectively ends in a purchase if, for example, the market has received an order by another investor that wants to sell at least 1000 shares even at 2.3 € or 2 orders by two investors who want to sell 500 shares each also at 2.3 €.

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Conclusions

This work should be a starting point for investors with no experience or with an average experience along the way to become an expert in financial markets.

With the simple concepts presented in the previous chapters, the reader has at least the minimum information necessary to begin in the complex world of investing in stocks. If you want to deepen your knowledge on the subject you can start with the masterpieces by Benjamin Graham and Philip Fisher, but the study could be long and complicated (Security Analysis is basically the Bible of the financial analysis!) While the truly useful information may be hidden in hundreds of pages of detailed analysis of the first â&#x20AC;&#x2DC;900 companies.

So, it is a hard work and it is not sure that will take you to a better way of investing. Or perhaps it is better that you find yourself the best way to improve your knowledge on the subject. We recommend you to start applying the investment system that we have illustrated in the book, gathering information, studying annual reports and forming your opinion on companies, and with your analysis in your hands, try to put into practice your "calculated " feelings. This text will already provide the basic knowledge you need and you do not need to deepen in the immediate, you can do it with the experience of trying to apply the concepts.

For example, many of the concepts in this book are original, they have been derived through experience and reflection by the author and have not been found in any other text, nor copied or adapted in any way. We refer in particular to: !149

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Deduction of the formula relating the price of a stock to the net profit of the company

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Average earnings of the last 10 years (perhaps only in one page of "Security Analysis" Benjamin Graham proposes the concept of average earnings, but he does not of it a crucial concept and without specifying that it should be done on 10 years);

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Hypothetical Gaussian distribution of P/E;

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ROE calculated on 10-year average earnings and considered as a factor in identifying long-term stocks

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Interpretation of a high ROE as likelihood of a future regular payment of dividends

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Creation of the index-based classification considering ROE, P/E, Capitalization and Dividend Yield

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Concept of the lower limit of 100% of losses and no upper limit in earnings

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Sensitivity of the investor as a quality factor for the selection of stocks and possible damage to the image after the purchase of certain stocks.

You can follow the daily updated rankings calculated with our system at the web site: www.theawareinvestor.com

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About the author

Antonio Sferra is a graduate in Computer Engineering. He started working as a computer consultant at some of the most important companies in the banking sector, mainly focusing on developing applications for Customer Service and web applications in banking. In parallel to his work, he became interested in finance and to study the main books in the world about financial markets.

In 2006 he obtained a Master of Business Administration (MBA), reinforcing some knowledge of the business world, in particular with regard to the financial aspects.

Dissatisfied with the theories proposed by the mass media and the lack of a clear and effective investment system, he has started to think about writing this text to share original theories that he has identified over time, using his computer skills to build an automatic classification of the stocks applying the theories identified and identifying day-to-day investment opportunities in the markets.

You can contact Antonio for reporting inaccuracies, suggestions or clarifications on the text to the email address: a.sferra@inwind.it.

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Appendix - Rankings on May 2013 of the most interesting stocks identified

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Rankings on May, 12th 2013 The rankings shown take into account 492 stocks, those that are found to be more interesting by the analysis of more than 1000 stocks around the world.

The first ranking shown is the most important, and it is the one on which we base our preference at all, because it takes into account companies with high ROE with preference for those undervalued (low 10-year average P/E), high dividend yield and high capitalization.

The ranking by ROE is not very different from the first, but it can be misleading because it does not take into account whether a company is overvalued by the market.

The ranking by P/E is completely different from the other two because it only takes into account the underestimation of the companies by the market. We strongly advise you not to use important parts of your capital on companies with very low P/Es, because they are potentially hazardous in case they do not record sufficient liquidity.

The ranking by market capitalization is the less important for us, but still useful to understand the amount of capital involved on the single stock.

The ranking by dividend yield considers only the gain obtained in the previous year considering only dividends paid.

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BEST INDEX (THE BEST 50 STOCKS IN WHICH TO INVEST AS CALCULATED BY OUR SYSTEM)

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BEST 50 ROE INDEX STOCKS (BEST LONG-HORIZON STOCKS).

ROE CALCULATED ON LAST 10-YEAR AVERAGE EARNINGS

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BEST 50 P/E STOCKS (UNDERVALUED STOCKS ON THE 10-YEAR AVERAGE NET EARNINGS)

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BEST 50 CAPITALIZATION STOCKS (POTENTIALLY MORE STABLE STOCKS)

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BEST 50 DIVIDEND YIELD STOCKS

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