The Study of Stock Market through Fundamental Analysis

Lesson -> The Final Conclusion

16.1 - The follies and  Discounted cash Flow (DCF) Analysis

We will be discussing a few key topics in this final chapter that can significantly affect how you make investment decisions. In the previous chapter, we learned how to calculate the intrinsic value using the Discounted cash Flow (DCF). The DCF method is one of the most reliable ways to determine a stock's intrinsic worth. The DCF method does have its limitations, which you should be aware of. The DCF model can only be as good as the assumptions it is fed. The fair value and stock prices computations could be affected if the assumptions are wrong.

  1. DCF requires that we forecast The DCF model is a way to forecast the future cash flow and business cycles. This is not only for the fundamental analyst, but also for the top management.
  2. Highly sensitive to the terminal growth rateThe terminal growth rate is a factor in the DCF model. Any small change in terminal growth rate could result in a significant difference in final output. The per-share value. In the ARBL case, for instance, we assumed that 3.5% would be the terminal growth rate. At 3.5%, the share price is Rs.368/. But, if this rate rises to 4.0% (an increase of 50 basis points), then it will be Rs.394/.
  3. Constant UpdatesAfter the model has been built, the analyst must continue to update and align it with any new data (quarterly or yearly). Regular updates are required for both the DCF model's inputs as well as its assumptions.
  4. Focus on the long termDCF is primarily focused on long-term investing and does not offer any opportunities to investors with a short-term focus. (i.e. 1-year investment horizon)

Because the DCF model is based upon certain parameters, it can also cause you to miss out on unique opportunities.

The only way to overcome the DCF Model's drawbacks is to be as conservative as possible when making assumptions. These guidelines are for conservative assumptions:

  1. FCF growth rateThe FCF must grow at a rate of 20% each year. Businesses cannot sustain a growth rate of 20% in their free cash flow. A company that is young and in high growth sectors may be able to grow its free cash flow by a little less than 20%. However, a company cannot earn a FCF growth rate greater than 20%.
  2. Some yearsThis can be a tricky one, but the longer it is, the better. However, a longer duration would allow for more errors. A 10 year, 2 stage DCF approach is my preference.
  3. 2 stage DCF valuationAs demonstrated in the ARBL example, it is always a good idea to divide the DCF analysis into two stages. I would increase the FCF growth rate in stage 1. In stage 2, however, I would decrease the rate at which the FCF is growing.
  4. Terminal Growth Rate- The DCF model is vulnerable to terminal growth, as I have already mentioned. It should be as simple and low-key as possible. Personally, I prefer it to be around 4% and not higher.

16.2 - The Safety Margin

Even though you make some cautious assumptions, there is always the possibility of things going wrong. How can you protect yourself from that? Here is where you will find the concept of "Margin of Safety". Benjamin Graham, a seminal author titled "Intelligent Investor", popularized the margin of safety thinking process. The margin of safety suggests that investors should only buy stocks when they are available at a price lower than the estimated intrinsic value calculation. The Margin of Safety is not an indicator of success in investing but it can be used to help avoid mistakes when calculating.

Here's how I apply the 'Margin of Safety principle to my own investment practices. Amara Raja Batteries Limited's intrinsic value estimate was approximately Rs.368/share. To create the intrinsic value range, we used a 10% modeling error. The lower intrinsic value estimate was Rs.331/. We are accounting for modelling errors at Rs.331/- Margin of Safety recommends that we further discount the intrinsic value. I like to reduce the intrinsic value by at least 30%.

It is important to not discount it any further. Aren't we extra conservative, you may ask? This is how you can protect yourself from bad assumptions and bad luck. If a stock is attractive at Rs.100 and then at Rs.70, it can be a safe bet. This is what value investors who are savvy do.

Let's go back to ARBL.

  1. The intrinsic value of Rs.368/ is Rs.368/
  2. Accounting for modeling errors @10%, Rs.331/-
  3. To account for safety margins, we would discount it by 30%. The intrinsic value would then be Rs.230/-
  4. With great conviction, I would buy this stock at 230/-

Value investors will pick up quality stocks that are significantly below their intrinsic value. If you have the margin of safety, you should buy it as soon as possible. Sweet deals such as this, where a stock is trading below its intrinsic value, are a great deal for long-term investors.

Remember that stocks with good prospects will be at great prices, especially in bear markets when stock market pessimists are very negative. You should ensure you have enough cash to shop during bear markets!

16.3 - When should I sell?

We have covered buying stocks throughout the module. What about selling stocks? How do we book profit? Let's say ARBL was bought at Rs.250 per share. It now trades at Rs.730/share. This is a 192% absolute return. This is a great return rate, especially considering that the return was generated in just over a year. Does that mean you can actually sell this stock and make a profit? The disruption in investible-grade attributes will determine whether you decide to sell.

Disruption of investible-grade attributesRemember that the stock's price does not determine whether or not you buy it. ARBL has not fallen 15%, so we don't buy it. ARBL is only bought because it meets the criteria of "investible grade attributes". We will not buy stocks that lack investible grade attributes. This logic dictates that we keep stocks so long as they have investible grade attributes.

The same attributes can be displayed by the company for many years. We will continue to invest in the stock as long as these attributes remain intact. These attributes will naturally increase the stock price, creating wealth for you. If any of these attributes show signs of deterioration, it is time to sell the stock.

16.4 - How many stocks are in your portfolio?

There is much debate about the number of stocks you should own in your portfolio. Although holding many stocks can help you spread risk, some argue that holding fewer stocks will allow you to make concentrated bets which could reap huge rewards. This is what legendary investors have said about the importance of having a small number of stocks in your portfolio.

Seth Klarman – 10 to 15 stocks

Warren Buffet - 5-10 stocks

Ben Graham - 10-30 stocks

John Keynes - 2 or 3 stocks

My personal portfolio currently contains 13 stocks. I wouldn't be content with owning more than 15. Although it is difficult to say how many stocks you should own, I think there is no reason to have a lot of stocks in your portfolio. Large is a number that I consider to be over 20.

16.5 - Final Conclusion

We have covered many topics in the markets and fundamental analysis over the 16 chapters. It is time to say goodbye and let me leave you with some last points I believe are important.

  1. Be reasonableMarkets are volatile. It is part of the beast. Markets can be quite rewarding if you are patient and willing to wait. When I say that markets can reward you fairly well, I mean a CAGR between 15-18%. This is a reasonable and reasonable expectation. Do not let abnormal returns of 50-100% in the short-term fool you. It may not be sustainable.
  2. Long-term approachThis topic is discussed in chapter 2. It is why long-term investors are important. Keep in mind that money compoundes faster the longer you are invested
  3. Look out for investment grade attributesInvest in stocks with investable grade attributes. Keep your investments in these stocks as long as they last. If the company does not have these attributes, book profits
  4. Respect qualitative research- Character is more important that numbers. Look for companies that have good character promoters.
  5. Reduce the noise and use the checklist- Don't listen to the TV/newspaper analyst who boasts about a company. To see if the checklist makes sense, you can use it as a guideline.
  6. Respect the safety marginThis literally acts as a safety net against bad luck
  7. IPOAvoid investing in IPOs. IPOs are often overpriced. If you are forced to invest in an IPO, analyze it using the same 3-stage equity research methodology.
  8. Continued LearningUnderstanding markets takes a lifetime effort. Learn new things every day and expand your knowledge.

Let me leave you with four book recommendations to help you build a great mindset for investing.

  1. Warren Buffet's Essays for Investors & Managers
  2. Joel Greenblatt's The Little Book That Beats the Market
  3.  Aswath Damodaran's The Little Book of Valuations
  4. The Little Book That Builds Wealth

These are my points and I'm going to close the Fundamental Analysis module. I hope you enjoy it as much as I did while writing this article.