4 stock picking steps

The stock should be cheap and safe; but more important than cheap is safe.

What makes a stock cheap?

The price must be at a big discount to the resources – that is, to the net asset value per share. Another way of describing net asset value is what a company would bring in a takeover. Whitman was more conscious of growth in readily ascertainable net asset value than in earnings per share.

What makes a stock safe?

• High quality resources

• The absence of liability

• The presence of cash

• High quality balance sheet

• Competent and shareholder-oriented management; a good management will convert resources into something of value

• Understandable and honest disclosure documents

The first thing to do is understand the business. Then arrive at the estimate of net asset value. Once done, look for a sizeable discount to this. Guard against investment risk but don’t give too much importance to market risk. (When it comes to the latter, Whitman parts ways with the fathers of value investing - Benjamin Graham and David Dodd, who were very conscious of how much one suffers when the price goes down.)

Never treat one accounting number as more important than another. They are all part of the whole. But depending on the company being analysed, preference should be accordingly given. If it is income-producing real estate, you look for appraisals. With a mortgage portfolio, you want a credit analysis and the yield to maturity.

If it’s a money manager, assets under management must be looked at. For financial guaranty insurers, it is adjusted Book Value (BV + the equity in the present value of certain future premiums).

The only way you know whether you have covered all bases is to look at the balance sheet. Taking the balance sheet at face value is often misleading. For example, if you look at a mutual fund management company, the AUM would have a ready market value even though it is not a balance sheet asset. Or, deferred income taxes for a firm. Since the company is going to reinvest cash savings when they aren’t paying taxes in assets which give rise to tax deductions, this account is really more like equity than a liability.

It’s a mistake to look at a business all by itself. Companies are engaged in mergers, acquisitions, massive financings, spinoffs, changes in control, and changes in assets and liabilities. Whitman calls these resource conversions, and notes that during a “resource conversion”, pricing is absolutely different than that it is in the stock market. In other words, what a private buyer will pay to control a company has nothing to do with what the listed stock currently sells for.

He believed that to truly identify high quality securities at discount prices, one must look at the business not only as a passive investor, but also from the point of view of the corporations, managements, and creditors. Besides primacy of the income account, companies and managements must be appraised in terms of their capabilities as operators. Look at management teams as investors and look at management as financiers. This will help give a balanced approach.

• Whitman believed that earnings are very overrated, but there are four ways corporate value is created.

• Cash flow from operations available for security holders, which is relatively rare. Earnings, with earnings being defined as creating wealth while consuming cash. In order to have earnings in the long term, the firm must remain credit worthy and have access to capital markets to meet cash shortfalls. One of the tools to predict future earnings is RoE, don’t be too preoccupied with past earnings trend.

• Resource conversion.

• Attractive access to capital markets. For instances, let’s say you own some income-producing real estate. Consequently, access to long-term nonrecourse debt to finance 70% or more of your project is a value creator.