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How To Evaluate The Quality Of EPS

bullbear — Tue, 29 Mar 2011 00:45:00 +0000

How To Evaluate The Quality Of EPS

by Rick Wayman

Earning per share (EPS) manipulation might be the second oldest profession, but there is a relatively easy way for investors to protect themselves. This article will show you how to evaluate the quality of any kind of EPS, and find out what it’s telling you about a stock.

Tutorial: Examining Earnings Quality
Overview
The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors, accompanied by constantly mutating versions that seem to have come out of “Alice in Wonderland”. Instead of Tweedle-Dee and Tweedle-Dum we have pro forma EPS and EBITDA. And, despite rumors to the contrary, the whisper number - the Cheshire cat of Wall Street – continues to exist as guidance.

To be fair, this situation cannot be totally blamed on management. Wall Street deserves as much blame due to its myopic focus on the near-term and knee-jerk reactions to 1 cent misses. A forecast is always only a guess – nothing more, nothing less – but Wall Street often forgets this. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions. (For background reading, check out Earnings Forecasts: A Primer.)

EPS Quality

High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated). But while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.

A low-quality EPS number does not accurately portray what the company earned. GAAP EPS (earnings reported according to Generally Accepted Accounting Principles) may meet the letter of the law but may not truly reflect the earnings of the company. Sometimes GAAP requirements may be to blame for this discrepancy; other times it is due to choices made by management. In either case, a reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions.

How to Evaluate the Quality of EPS

The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with theSEC.

To determine earnings quality, investors can rely on operating cash flow. The company can show a positive earnings on the income statement while also bearing a negative cash flow. This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected. “Cash is king” is one of the few real truisms on Wall Street, and companies that don’t generate cash are not around for long. Want proof? Just look at how many of the dotcom wonders survived! (To learn more about what happened, see Why did dotcom companies crash so drastically?)

If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS, earnings are of a high quality because the company is generating more cash than is reported on the income statement. Reported (GAAP) earnings, therefore, understate the profitability of the company.

If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. In this case, EPS is of low quality because it does not reflect the negative operating results of the company and overstates what the true (cash) operating results.


Watch: Earning Per Share

An Example
Let’s say that Behemoth Software (BS for short) reported that its GAAP EPS was $1. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.

However, if BS’s operating cash flow per share were a negative 50 cents, it would indicate that the company really lost 50 cents of cash per share versus the reported $1. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The 50 cent negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.

If BS’s operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was 50 cents more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment. (To learn more about this metric, check out Operating Cash Flow: Better Than Net Income?)

Trends Are Also Important

Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends. It is possible that an entire industry may generate negative operating cash flow due to cyclical causes. Operating cash flows may be negative also because of the company’s need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.

Evaluating trends will also help you spot the worst-case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, the need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. The appearance of growing GAAP EPS even though the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover. (To learn about why companies fudge cash flow, readCash Flow On Steroids: Why Companies Cheat.)

The Bottom Line

Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. Luckily, it is relatively easy for investors to evaluate the situation.

by Rick Wayman (Contact Author | Biography)

Filed Under: Accounting, Fundamental Analysis, Stock Analysis, Stocks

http://www.investopedia.com/articles/analyst/03/091703.asp

Philip Fisher: Quality first, Price second

bullbear — Wed, 23 Feb 2011 22:58:00 +0000

Fisher formulated a clear and sensible investing strategy (which I’ll get to in a second), wrote one of the best investment books of all time, Common Stocks and Uncommon Profits, and made a good deal of money for himself and his clients.

His son wrote that Phil’s best advice was

to “always think long term,”
to “buy what you understand,” and
to own “not too many stocks.”

Charles Munger, who is Buffett’s partner, praised Fisher at the 1993 annual meeting of their company, Berkshire Hathaway Inc. (BRK/A): “Phil Fisher believed in concentrating in about 10 good investments and was happy with a limited number. That is very much in our playbook. And he believed in knowing a lot about the things he did invest in. And that’s in our playbook, too. And the reason why it’s in our playbook is that to some extent, we learned it from him.”

In addition to the warning against over-diversification — or what Peter Lynch, the great Fidelity Magellan fund manager, calls “de-worse-ification” — the book makes three important points:

(1) First, don’t worry too much about price. (Quality first, Price second)

“Even in these earlier times [he's talking here about 1913], finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear.”

In fretting about whether a stock is cheap or expensive, many investors miss out on owning great companies. My own rule is: quality first, price second.

(2) Second, Fisher says that investors must ask, “Does the company have a management of unquestionable integrity?”

(3) Finally, Fisher offered the best advice ever on selling stocks. “It is only occasionally,” he wrote, “that there is any reason for selling at all.”

Yes, but what are those occasions? They come down to this: Sell if a company has deteriorated in some important way. And I don’t mean price!

Fisher’s view, instead, is to look to the business — the company itself, not the stock.

“When companies deteriorate, they usually do so for one of two reasons:

Either there has been a deterioration of management, or
the company no longer has the prospect of increasing the markets for its product in the way it formerly did.”

A stock-price decline can be a key signal: “Pay attention! Something may be wrong!” But the decline alone would not prompt me to sell. Nor would a rise in price.

Time to sell? If you did, you missed another doubling.

“How long should you hold a stock? As long as the good things that attracted you to the company are still there.”

http://myinvestingnotes.blogspot.com/2010/09/learning-from-long-men-late-phil-carret.html

Quality Investing

bullbear — Sat, 22 Jan 2011 23:27:00 +0000

Quality investing
From Wikipedia, the free encyclopedia

Quality investing is an investment strategy based on clearly defined fundamental factors that seeks to identify companies with outstanding quality characteristics. The quality assessment is made based on soft (e.g. management credibility) and hard criteria (e.g. balance sheet stability). Quality Investing supports best overall rather than best-in-class approach as the specific industry’s or country’s quality is evaluated as well.

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[edit]History

The idea for quality Investing originated in the bond and real estate investing, where both the quality and price of potential investments are determined by ratings and expert attestations. Later the concept was applied to enterprises in equity markets.

Benjamin Graham, the founding father of value investing, was the first to recognize the quality problem among equities back in the 1930s. Graham classified stocks as either quality or Low quality. He also observed that the greatest losses result not from buying quality at an excessively high price, but from buying Low quality at a price that seems good value.^[1]

The quality issue in a corporate context attracted particular attention in the management economics literature following the development of the BCG matrix in 1970. Using the two specific dimensions of life cycle and the experience curve concept, the matrix allocates a company’s products – and even companies themselves – to one of two quality classes (Cash Cows and Stars) or two Non-quality classes (question Marks and Dogs). Other important works on quality of corporate business can be found primarily among the US management literature. These include, for example, “In Search of Excellence” by Thomas Peters and Robert Waterman^[2], “Built to Last” by Jim Collins and Jerry Porras^[3], and “Good to Great” by Jim Collins^[4].

Quality Investing gained credence in particular after the burst of Dot-com bubble in 2001 when investors learned of the spectacular failures of companies such as Enron and Worldcom. These corporate collapses focused investors’ awareness of quality from stock to stock. Investors started to pay more attention to quality of balance sheet, earnings quality , information transparency, corporate governance quality.

[edit]Identification of Corporate quality

As a rule, systematic quality investors identify quality stocks using a defined schedule of criteria that they have generally developed themselves and revise continually. Selection criteria that demonstrably influence and/or explain a company’s business success or otherwise can be broken down into five categories:^[5]

1. Market Positioning: quality company possesses an economic moat, which distinguishes it from peers and allows to conquer leading market position. The company operates in the industry which offers certain growth potential and has global trends (e.g. ageing population for pharmaceuticals industry) as tailwinds.

2. Business model: According to the BCG matrix, the business model of a quality company is usually classified as star (growing business model, large capex) or cash cow (established business model, ample cash flows, attractive dividend yield). Having a competitive advantage, quality company offers good product portfolio, well-established value chain and wide geographical span.

3. Corporate Governance: Evaluation of corporate management execution is mainly based on soft-criteria assessment. Quality company has professional management, which is limited in headcount (6-8 members in top management) and has a low turnover rate. Its corporate governance structure is transparent, plausible and accordingly organized.

4. Financial Strength: Solid balance sheet, high capital and sales profitability , ability to generate ample cash flows are key attributes of quality company. Quality company tends to demonstrate positive financial momentum for several years in a row. Earnings are of high quality, with operating cash flows exceeding net income, inventories and accounts receivables not growing faster than sales etc.

5. Attractive valuation: Valuation ultimately is related to quality, which is similar to investments in real estate. Attractive valuation, which is defined by high discounted cash flow (DCF), low P/E ratio and P/B ratio, becomes an important factor in quality investing process.

According to a number of studies the company can sustain its quality for about 11 months in average, which means that quantitative and qualitative monitoring of the company is done systematically.

[edit]Comparison to other investment models

Quality investing is an investment style that can be viewed independent of value investing and growth Investing. A quality portfolio may therefore also contain stocks with Growth and Value attributes.

Nowadays, Value Investing is based first and foremost on stock valuation. Certain valuation coefficients, such as the price/earnings and price/book ratios, are key elements here. Value is defined either by valuation level relative to the overall market or to the sector, or as the opposite of Growth. An analysis of the company’s fundamentals is therefore secondary. Consequently, a Value investor will buy a company’s stock because he believes that it is undervalued and that the company is a good one. A quality investor, meanwhile, will buy a company’s stock because it is an excellent company that is also attractively valued.

Modern Growth Investing centers primarily on Growth stocks. The investor’s decision rests equally on experts’ profit forecasts and the company’s earnings per share. Only stocks that are believed to generate high future profits and a strong growth in earnings per share are admitted to a Growth investor’s portfolio. The share price at which these anticipated profits are bought, and the fundamental basis for growth, are secondary considerations. Growth investors thus focus on stocks exhibiting strong earnings expansion and high profit expectations, regardless of their valuation. Quality investors, meanwhile, favor stocks whose high earnings growth is rooted in a sound fundamental basis and whose price is justified. (QVM approach)

References

^ Benjamin Graham (1949). The Intelligent Investor , New York: Collins. ISBN 0-06-055566-1.
^ Thomas Peters and Robert Waterman (1982). In Search of Excellence. ISBN 0-06-015042-4
^ Jim Collins and Jerry Porras (1994). Built to Last. ISBN 978-0887307393
^ Jim Collins (2001). Good to Great . ISBN 978-0-06-662099-2
^ Weckherlin, P. / Hepp, M. (2006). Systematische Investments in Corporate Excellence, Verlag Neue Zürcher Zeitung. ISBN 3-03823-278-5.

Most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

bullbear — Wed, 19 Jan 2011 23:20:00 +0000

The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.

Chapter 20 – “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

Ben Graham: The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

bullbear — Mon, 17 Jan 2011 23:19:00 +0000

Chapter 20 – “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

The coming flight to quality stocks

bullbear — Wed, 27 Oct 2010 22:31:00 +0000

Posted by Scott Cendrowski, reporter
October 27, 2010 1:40 pm

Leave it to Jeremy Grantham to blast Fed Chairman Ben Bernanke and former chairman Alan Greenspan in a rightfully scary missive titled “Night of the Living Fed.”

Jeremy Grantham, the institutional money manager in Boston who oversees nearly $100 billion, has been as critical of the Fed’s interest rate policies over the past 15 years as he has been adept at spotting bubbles fueled by the low rates. He warned clients of tech stocks more than a decade ago and more recently called a worldwide asset bubble before the meltdown in 2008. (Though he’s labeled a perma-bear, Grantham pounces on opportunities: on March 10, 2009, at the market’s lows, he encouraged clients to load up on stocks in a note titled “Reinvesting When Terrified.”)

His latest quarterly note reminds investors how dangerous it is for Bernanke and Co. to rely on ultra-low interest rates, and the resulting cheap debt, to promote economic growth. “My heretical view is that debt doesn’t matter all that much to long-term growth rates,” he writes. “In the real world, growth depends on real factors: the quality and quantity of education, work ethic, population profile, the quality and quantity of existing plant and equipment, business organization, the quality of public leadership (especially from the Fed in the U.S.), and the quality (not quantity) of existing regulations and the degree of enforcement.”

A graph of total debt compared to U.S. GDP growth drives home the point: as the U.S. tripled its debt compared to GDP in the past three decades, GDP growth slowed to 2.4% from its 100-year average of 3.4%.

Read Grantham’s entire note below (and we really encourage you to do so, even if it takes the better part of an afternoon). The most sobering section must be the effect that near zero percent interest rates has on retirees in the U.S.

“When rates are artificially low, income is moved away from savers, or holders of government and other debt, toward borrowers,” Grantham writes. “Today, this means less income for retirees and near-retirees with conservative portfolios, and more profit opportunities for the financial industry; hedge funds can leverage cheaply and banks can borrow from the government and lend out at higher prices or even, perish the thought, pay out higher bonuses. This is the problem: there are more retirees and near-retirees now than ever before, and they tend to consume all of their investment income.”

Flight to quality

Since Grantham is foremost a stock investor, we’ll let you read his criticisms and instead highlight what he thinks it means for stocks. Grantham’s takeaway: don’t fight the Fed.

Stocks, which are overvalued by historical standards, can still run up 20% or more, he says.

Year three of a presidential cycle is typically a good time for stocks. Since FDR’s presidency, some 19 cycles have passed with only one bear market. That, coupled with low short-term interest rates, leads Grantham to affix 50/50 odds on the S&P 500 Index reaching 1,400 or 1,500 in the next year.

“There is also the definite possibility that we could slide back into a double dip, so we may get lucky and have a chance to buy cheaper stocks,” he writes. “But probably not yet. And, of course, if we get up to 1400 or 1500 on the S&P, we once again face the consequences of a badly overpriced market and overextended risk taking with six of my predicted seven lean years still ahead.”

To cope with seven lean years (more here), Grantham still proselytizes high-quality stocks: the 25% of companies in the S&P 500 with low-debt and high, stable returns.

“For good short-term momentum players, it may be heaven once again,” he writes. “Being (still) British, this is likely to be my nth opportunity to show a stiff upper lip.” And it may be easier even for average investors, he observes, to buy high-quality blue chips because they are getting “so cheap” relative to the market.

Recently, in the largest stock rally since 1932, Grantham often notes, high-quality blue chips have trailed the speculative, debt-laden companies within the S&P 500. He writes that chances are one in three that, come another rally in the next year, high-quality stocks will join in. “….Quality stocks are so cheap that they will ‘unexpectedly’ hang in,” he writes.

http://finance.fortune.cnn.com/2010/10/27/the-coming-flight-to-quality-stocks/

Investing for long term is a better strategy

bullbear — Mon, 04 Oct 2010 09:12:00 +0000

3 Oct, 2010, 05.56AM IST,
Ashish Gupta,ET Bureau

Investing for long term is a better strategy

With the breaching the 20,000 mark and looking good for 21,000, what should be the strategy of individual investors? Should they take the plunge? Normally, during times like these, everything sells. Look at the number of IPOs hitting the market in such a short span of time and demanding huge premiums. And most were a running success.

The fast-growing economy has pushed the growth process. The most important factor has been the sustained foreign institutional investor (FII) interest in the markets that gave the Sensex its big thrust. Inflow of foreign capital and strong economic are behind the optimism in the markets.

FII factor

Although bull phases are good, need to be cautious. A bull run is good news for investors. However, some analysts expect a correction. A deep correction could create panic among investors who may resort to booking profits. Such a situation is more likely as the index rise has been rapid and unexpected. Moreover, as the bull run is largely due to foreign capital flows, the market direction is highly unpredictable.

This is because FII sentiment is impacted by global developments and trends. Many factors may trigger a fall. A slowdown in growth, political developments, employment data, inflation -anywhere in the world -could have an impact. In case the start pulling out, it may lead to a financial concern. It is better for small investors to be cautious lest there is a deep correction.

Go by fundamentals

Further, investors should invest in and stick to fundamentally-strong companies. The stocks of these companies are normally stable and grow at a steady pace. They are neither affected by booms nor by falls. They tend to weather volatile times well. Investors should ideally invest in large-cap stocks. These are less risky than small-cap stocks. Although small-cap stocks have tremendous growth potential, they carry a higher potential of downsides.

Diversify portfolio

You should also diversify your portfolio. There should be a mix of debt and equity. A reasonable portion should be invested in debt, offering secured returns. The entire funds should not be parked in equity. Although it has the potential to provide higher returns, the equity route also carries with it the inherent risks of a downside as well. Also, borrowed funds should not be used to invest in the markets. One should look at strong, growing sectors that hold potential for growth. Even in these growing sectors, you should choose the fundamentally-strong companies.

http://economictimes.indiatimes.com/features/financial-times/Investing-for-long-term-is-a-better-strategy/articleshow/6672767.cms

Big blue chips not always beautiful

bullbear — Wed, 29 Sep 2010 14:34:00 +0000

John Wasiliev

September 28, 2010

Blue chip shares are supposed to be the best stocks an investor can own. They are regularly put forward by brokers, analysts and commentators as solid and dependable with the capacity to deliver reliable returns over the long term.
This image is helped by the fact they are mostly among the largest companies on the share market and when times get tough big can often be better. Or is it?
After the share market crashed in 2007 to 2008, it was the blue chips that were recommended as the safest options for investors or prospective share investors looking to establish a core portfolio.
Back in September 2008, for instance, the recommended blue chips included BHP Billiton and Rio Tinto, all the big four banks, gold miner Newcrest, oil giant Woodside, transport services company Brambles, the health industry twins CSL and Cochlear, retailer Woolworths, energy sector leader AGL and telecommunications leader Telstra.
It’s worth looking back to see how these shares have performed. Two years ago, for example, in late September 2008, BHP shares were trading at around $35.80 and Rio shares were priced at $79.60. Newcrest shares were trading at around $21 and Woodside at $49.60 with Brambles at $8.40. Westpac shares were trading at $24 and Commonwealth Bank shares at $44.40. CSL shares were at $38.20, Woolworths at $28.10 and Telstra at $4.35.
By comparison as September 2010 comes to a close, BHP shares are trading higher at $39.20, Rio shares are lower at $76, Newcrest has soared to $41, Woodside has dropped to $44.40, Westpac is flat at $24, Commonwealth shares are better are $52.40, CSL has slipped to $33.70, Brambles is down to at $6.20, Woolworths is holding at $28.90 and Telstra has plunged to $2.70. What this performance scoreboard shows is that over this period there have been winners and losers among the blue chips.
Some investors who listened to the blue chip story would be happy, while others might regard investing in what are promoted as the best shares you can buy as being an easy way of losing money.

The lesson in this missed bag of returns, says Elio D’Amato of share market researcher Lincoln Indicators, is that just because a company is big does not guarantee its success. Big is not necessarily beautiful and because a big company is or isn’t doing as well as others often has little to do with its size.

Rather than size, he says, what determines whether a company is performing well on the share market will have more to do with factors such as the business it is in and how well it is responding to different challenges.

It is an argument, he says, in favour of investing in profitable companies of all sizes rather than just big companies. That’s not to say big companies can’t stand out at times. Gold miner Newcrest, for example, has benefited from the fact the price of gold has risen from about $US800 an ounce in September 2008 to just under $US1,300, a more than 60 per cent gain.
At the other end of spectrum, Telstra’s profit performance has been lacklustre and this is reflected in its depressed price. It’s been a similar disappointing profits story with Brambles.
D’Amato says there might be special reasons why some are lagging. For example, CSL has had to face the challenges of a rising Australian dollar because a sizeable proportion of its profits are earned overseas and must be converted back to Australian dollars when they are distributed to investors.
Two years ago the $US-Australian dollar exchange rate was US83c compared to the most recent price of US95c.

http://www.smh.com.au/money/on-the-money/big-blue-chips-not-always-beautiful-20100924-15pul.html

The Value Equation

bullbear — Sat, 31 Jul 2010 14:54:00 +0000

Buffett:”Turnarounds” seldom turn. Be in a good business purchased at a fair price than in a poor business purchased at a bargain price.

bullbear — Wed, 31 Mar 2010 00:16:00 +0000

Warren Buffett in his 1978 letter to his shareholders places a great deal of importance on the quality of business and also the fact that he had to let go of many attractive investment opportunities just because the price was not right. In the following write up, let us see what the master has to offer in terms of investment wisdom in his 1979 letter:

“The inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) – can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.“

The above paragraph clearly demonstrates that in order to improve one’s purchasing power, one will have to earn after tax returns that are higher than the inflation rate at all times. Imagine a scenario where the inflation rate touches 9%, which means that a commodity that you purchased at Rs 100 per unit last year will now cost you Rs 109. Further, assume that you put Rs 100 last year in a business that earns 10% return on equity and the tax rate that currently prevails is 20%.

Thus, while you earned Rs 10 by virtue of the 10% return on equity, the tax rate ensured that only Rs 8 has flown to your pocket. Not a good situation since your purchasing power has diminished as while your returns were only 8% post tax, you will have to shell out Re 1 extra for buying the commodity as inflation has remained higher than the after tax returns that you have earned. Further, high inflation does not help the business too unless it has some inherent competitive advantages, which enables it to pass on the hike in inflation to the end consumers. Little wonder, investors lay such high emphasis on businesses that earn returns way above inflation so that the purchasing power is enhanced rather than diminished.

“Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.”

In the above paragraph, the master once again extols the virtues of a good quality business and says that he would rather pay a reasonable price for a good quality business than pay a bargain price for a poor business. It would be worthwhile to add that in the early part of his investing career, the master himself was a stock picker who used to rely only on quantitative cheapness rather than qualitative cheapness. However, somewhere down the line, he started gravitating towards good quality businesses and out of this thinking came such quality investments as ‘Coca Cola’ and ‘American Express’. These were the companies that

had virtually indestructible brands (a very good competitive advantage to have),
generated superior returns on their capital and
had ability to grow well into the future.

We prod you to find similar businesses in the Indian context, pick them up at a reasonable price and hold them for as long as you can. For if the master has made millions out of it, we don’t see any reason as to why you can’t.

http://www.equitymaster.com/detail.asp?date=7/5/2007&story=1

Indonesian Stock Market » buy quality

How To Evaluate The Quality Of EPS

How To Evaluate The Quality Of EPS

Philip Fisher: Quality first, Price second

Quality Investing

Contents

[edit]History

[edit]Identification of Corporate quality

[edit]Comparison to other investment models

References

[edit]See also

Most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

Ben Graham: The chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

The coming flight to quality stocks

Investing for long term is a better strategy

Big blue chips not always beautiful

John Wasiliev

The Value Equation

Buffett:”Turnarounds” seldom turn. Be in a good business purchased at a fair price than in a poor business purchased at a bargain price.