Part 3

1. The Five rules for successful
stock investing – Part 4
By : Pat Dorsey

2. Chapter 9 Valuation (Basics)
• Here I am pointing out some key pointers from the chapter :
• Be picky with valuation. You’ll do well over the long haul by buying companies that are undervalued, relative to their
earning potential. – always look for co.’s that are undervalued and has high earning potential
• Don’t rely on any single valuation metric because no individual ratio will tell us the whole story, we have to apply a
number of different valuation tools when you’re assessing the stock – we will have to apply all the valuation tools
because different valuation metrics will give us different insights about the company.
• We should check the earning yield, and cash return, & compare them with the rates available on bonds. AN earning
yield and cash return above current bond rates can indicate an undervalued stock – since we are searching and trying
to find an undervalued stock, so therefore we should consider earning yield and cash return where if they are above
bond rate, it will mean that the company has the potential to earning good return than the opportunity cost.
• We can compare P/E ratio with the market, with similar firms or with the the company’s historical P/E. In each case
we will want the P/E of the company to be lower than the benchmark, but we should make sure that we are aware
there are differences in risk and growth rates between the company we’re valuing and the benchmark. Most reliable
benchmark, is likely to be the company’s own historical valuation, assuming the company hasn’t changed very much
over time. - when the P/E which is being compared on a time series and cross sectional basis, also it is being
compared with the sector, we always expect it to be less, for the reason which is it should be able to show earnings
potential, and when it does, the stock price will automatically will boost.

3. • Use the PEG ratio which is another metric of P/E ratio that is calculated by dividing the P/E by its growth rate, the PEG ratio
is extremely popular with some investors, we should use the PEG ratio with caution because fast growing firms tend to be
riskier. We shouldn’t overpay for expected growth that may never materialize.
This point informs us that we should validate the stock’s growth first and then check the PEG ratio.
• The Price/Book ratio is the most useful for financial firms and the firms with numerous tangible assets, and its least useful
for service oriented firms. In addition, firms with higher ROEs, firms will be typically be worth a higher P/B ratio.
One of the key metric to check for Financial firm will be the Price/Book value ratio where it’ll show us the
importance of the asset in relation to price of the share.

4. Chapter 23 Consumer Goods
Though this mature sector is unlikely to grow much faster than the general economy, relatively static demand for food,
beverage, household, and tobacco products can add up to fairly steady performance. Further many companies enjoy wide
economic moats. These economic moats are are sustainable competitive advantages that translate into pricing power and
profitability. Though companies in this sector may seem boring, without the thrills of more risky categories, we like stability,
relatively low risks, and importantly generous free cash flow.
Here we will understand the chapter with some pointers :
• Find companies that enjoy the cost advantages of manufacturing on a larger scale than most other competitors. One
related issue is whether the firm holds dominant market share in its category - We should examine that the
consumer goods companies are having any cost advantage in manufacturing of the product, check Gross margins,
EBITDA margins, check whether cash is coming in.
• We should check for the firms that consistently launch successfully new products all the better if the firms is the first
to market with these innovations. – check whether the firms peers reaction on the new product launch and on the
innovation being created by the firm. Check the market share across time period and across sectional.
• Examine how well the firm is handling the operating costs, occasionally restructuring can help squeeze out efficiency
gains and lower costs, but if the firm is regularly incurring restructuring costs and relying solely on the cost cutting
strategy to boost its business, then we need to be wary of it. - check whether the firms are able to increase the
productivity of the business with occasionally restructuring and whenever the maintenance is required.

5. • Check to see if the company is constantly supporting its brand with consistent advertising, if the firm constantly promotes
its products with sale prices, its simply depleting the brand equity and looking for short term gains. - This is a point for
consumer goods businesses to check for, whether they are reducing their brand value with competing on the sales price,
where only the matured firms are able to compete on a certain extent.
• Because these mature firms generate so much free cash flow, its important to make sure management is using it wisely,
how much of the cash is turned over to shareholders in the form of dividends or share repurchases? - check whether the
owners of the shares are satisfied with the business with the investments they are invested in, whether they are getting
paid dividends and interests with certainty after generating consistent FCFF, and having good profitability and consistency.

6. Chapter 24 - Industrial materials
• This is a very traditional old economy sector, with many hard assets and high fixed costs. -
• Industrial materials are divided into commodity producers (steel, chemicals) and producers of
value added goods and services (machinery, some special chemicals) – For this we need to
examine their Gross Profit margin overall on a time series basis, cross sectional basis, also with
product basis, try to find out which are Value added Goods, which will increase their profitability
and earnings.
• The sales and profit in this sector are very sensitive to the business cycle – Analyze the business
with proper business cycles, and check how are they able to perform in the worst phase of the
business cycles.
• Only the most efficient producers will survive the downturn, (the best bet is to be low cost
producers and own little debt) – this point significates the business to perform well in the
headwinds, (bad weather for the business), in a sense where the business shall have low cost
strategies and little debt to take a beating.

7. • Buyers of commodities choose their products on price, otherwise commodities are the same product, regardless who
makes them – business which are dealing into commodity shall be able to take advantage of crisis type situations for
purchasing commodities for the business.
• Watch out for industrial firms that have too much debt, large underfunded pension plans and big acquisitions that distract
management – All these are the redf lags discussed in the above chapters, where it warns an investors to invest in.
• Asset turnover (total asset turnover and fixed asset turnover) are the great metrics to measure a manufacturing firm’s
efficiency. - If the business is doing CAPEX and still not be able to generate sales, then the business has invested into
unproductive assets, be wary of that, also do time series and cross sectional analysis.
• Very few industrial materials companies have any competitive advantages, the exceptions are those in the concentrated
industry (eg. Defense), those with the specialized niche products (some chemical makers), those that can produce their
goods at the lowest cost. - check all the pointers regarding investing in such sectors, where peer analysis and time series
analysis will help the business a lot in analyzing which firm are being able to sell and make profit with Definity.