Taken from The Five Rules For Successful Stock Investing, by Pat Dorsley
When not to sell a stock:
- The Stock has dropped
- The Stock has skyrocketed
When to sell a stock:
- Did you make a mistake?
- Have fundamentals deteriorated?
- Has stock risen too far above its intrinsic value?
- Is There Something better you can do with the money?
- Do you have too much money in one stock?
Seven mistakes to avoid:
- Swinging for the fences. This means that buying risky stocks (like small caps), finding the next Microsoft when it’s still a tiny start-up is next to impossible.
- Believing that it’s different this time. History does repeat itself, bubbles do burst, and not knowing market history is a major handicap.
- Falling in love with the products. For example: Palm was the first company to invent a handheld organizer that was relatively easy to use and affordable, but consumer electronics is simply not an attractive business. Margins are thin, competition is intense, and it’s very tough to make a consistent profit.
- Panicking when the market is down. In the words of Sir John Templeton, “The time of maximum pessimism is the best time to buy.
- Trying to time the market.
- Ignoring valuation. The only reason you should ever buy a stock is that you think the business is worth more than it’s selling for – not because you think a greater fool will pay more for the shares a few months down the road.
- Relying on Earnings for the whole story. Cash flow is what matters, not earnings.
If operating cash flows stagnate or shrink even as earnings grow, it’s likely that something is rottern
Economic Moat – What makes great company great.
To analyze a company’s economic moat, follow these four steps:
I. Evaluate the firm’s historical profitability.
- Look for line item labeled “cash flow from operations” and subtract with “capital expenditure”.
- Next, divide free cash flow by sales (or revenues), which tells you what proportion of each dollar in revenue the firm is able to convert into excess profits.
If a firm’s free cash flow as a percentage of sales in around 5% or better, you have found a cash machine.
- Look for Net Margin = Net income as a percentage of sales.
Firms that post net margins > 15% are doing something right
- Look for Return in Equity (ROE) = net income as a percentage of shareholders’ equity, and it measures profits per dollar of the capital shareholders have invested in a company.
Firms that are able to consistently post ROEs above 15% are generating solid return on shareholder money.
- Look for Return on Assets (ROA) = net income as a percentage of a firm’s assets, and it measures how efficient a firm is at translating its assets into profits
Use 6% to 7% as a rough benchmark
II. If the firm has solid returns on capital and consistent profitability, assess the sources of the firm’s profits.
The key question here is : WHY. Why no competitor on horizon?, why customer keep on accepting price increase?
In general, there are 5 ways that an individual firm can build sustainable competitive advantage:
- Creating real product differentiation through superior technology or features (NARROW MOAT).
- Creating perceived product differentiation through a trusted brand or reputation (DEEP MOAT).
- Driving costs down and offering a similar product or service at a lower price. This especially works in commodity industries, in which products are tough to differentiate. Also, it worth to mention that firms can create cost advantage by either inventing a better process (e.g. Dell) or achieving a larger scale / economy of scale (e.g. Intel). (DEEP MOAT)
- Locking in customers by creating high switching costs. You can make it difficult in terms of either money or time for a customer to switch to a competing product. Ask the following questions: (a) need significant amount of client training?; (b) tightly integrated into customers’ businesses?; (c) is it industry standard?; (d) is the benefit to be gained from switching small relative to the cost of switching?; (e) any long term contract with client? (DEEP MOAT)
- Locking our competitors by creating high barriers to entry or high barriers to success. The most obvious way to lock out competitors is to acquire some king of regulatory exclusivity, like licenses, patents. A much more durable strategy for locking out competitors is to take advantage of the network effect like e-bay, western union. (DEEP MOAT)
III. Estimate how long a firm will be able to hold off competitors. Some can do it in years, some in months.
IV. Analyze the industry’s competitive structure. Hint: Use porter five forces.
