Stocks | Sell Side Handbook

For the purposes of our investing section, we look at stocks from an academic¹ and a value investing perspective. In our industry and career sections, we look at stocks based on how market participants approach stocks. This distinction may explain any differences in philosophy or voice within the website.

This post is currently under construction…

Contents

1 Understanding Stocks and Valuing Stocks
2 Stock Case Study – Nancy’s Candy Emporium
3 The Time Value of Money and Quantifying the Risk-Adjusted Discount Rate
4 Setting a Floor with the Risk-Free Rate
5 Understanding Inflationary Risk
6 Operational Risks for a Business
7 Case Study 2: Big Nancy’s Candy Empire Discount Rate
8 The Business Moat
9 Secular Industry Trends and Avoiding Declining Sectors
10 Stock Investing Conclusions
11 Related Reading for Investing
- 11.1 Investment Asset Classes
- 11.2 Commentary on Investing

Understanding Stocks and Valuing Stocks

Stocks represent fractional ownership in a business. As an investor, it is important to strip away all the noise and look at the intrinsic value of what that ownership is. A good way to look at this is to step back and ignore the financial paper that stock is and to value the business first. When this approach is taken, we can ignore the stock market.²

Theoretically, the value of a business is the present value of the sum of its future cash flows.

Stock Case Study – Nancy’s Candy Emporium

In an illustrative example, Nancy decides to open a candy shop in Melbourne that sells unique Japanese confectionery.

Nancy sells to 100 customers a day, with an average ticket (average spend) of $10. Average daily sales amount to $1,000. Average annual sales amount to $300,000.

Nancy imports the candy from Japan and has to pay customs, shipping and tax. She hires five international students on working visas to run her store. Nancy rents out a two-floor commercial unit in a Class A retail property and has to pay for utilities (electricity, hydro) and other overhead.

After all of her expenses and inclusive of corporate tax, Nancy pockets $150,000.

Let’s say Nancy wants to sell a stake in her company. If we are an investor, what is Nancy’s candy shop worth?

Let’s say that Nancy’s Candy Emporium only has one more year left of operation. Nancy’s landlord has told her he plans on selling the building to a developer looking to build a high rise and Nancy is planning on retiring. At most, we would be willing to pay $150,000 for the company because that is the cash flow that we are likely to receive.

However, we are unlikely to pay $150,000 for the company because of the uncertainty of the cash flow one year down the road.

In reality, almost all businesses we consider investing in are going concerns – they are looking to operate long-term and grow. For the rest of our case study, we can assume there is no offer for the landlord and Nancy has a reasonably long lease with no intention of retiring.

The Time Value of Money and Quantifying the Risk-Adjusted Discount Rate

A dollar today is not worth the same as a dollar tomorrow. This is because there are several risks and inconveniences associated with receiving money later.

As a basic comparison, what would most people prefer?

$100 right now
$100 from a stranger in a crime-ridden part of town in 1-year

Every rational person would prefer option A, as there are a number of uncertainties pertaining to payment. The value of a $100 right now is straightforward – it is $100. For Option B, a rational person would be willing to pay less than $100 to receive that $100 in one year to compensate for the risk. To look at it from another angle, the owed payment of $100 needs to be discounted (or take a haircut) to make it an acceptable investment.

In evaluating a business, there are many risks that need to be factored into the appropriate discount rate. The riskier the company, the higher a discount rate we should apply to its cash flows.

Setting a Floor with the Risk-Free Rate

As a floor, there is a minimum discount rate – the risk-free rate. The safest and more certain cash flow is the interest rate on a federal government bond. While the government could theoretically default, there is no more creditworthy counterparty than the entity that controls money itself.

The discount rate we apply to our potential investment should never be below the risk-free rate as the cash flows from the business are much less certain. With that in mind, here are some of the other risks we must consider before coming to a reasonable assessment of what Nancy’s Candy Shop is worth.

Understanding Inflationary Risk

Money is not a hard, consumable good and most countries will experience price inflation as wages rise. For instance, $100 may currently be enough 20 packets of Strawberry Pocky from Nancy’s Candy Emporium.

One year later, Nancy’s suppliers (Glico) increase their costs and Nancy must preserve her margin, so she increases her price. Now, $100 only purchases 18 packets of Strawberry Pocky. If you look at purchasing power by Pocky packets, you are effectively poorer with $100 in one year’s time. $100 in one year may be worth $90 today.

Based on the expected loss of purchasing power, we are unlikely to pay more than $90 for $100 in one year. To some extent, inflationary risk is already factored into the risk-free rate. Also, stocks are a natural inflation hedge because an operating business will increase its prices along with costs.

Operational Risks for a Business

Identifying what risks are and the probabilities of affecting the business is an exercise that requires ample research and thoughtful reflection.

Even for a simple candy shop making $150,000 per year, we have to look at opportunities for growth and threats to our base case cash flow. Given Nancy’s small scale and ostensibly replicable business, the appropriate risk factor could be quite high.

Nancy is currently a small buyer purchasing from a large food conglomerate that reports in a foreign currency. Nancy does not have a substitute in terms of goods purchased – buyers go to her store to purchase a very particular product. As such, we can expect that she has limited pricing power that is at the mercy of 1) Glico’s selling price and 2) adverse foreign exchange fluctuations.

How risky this is to Nancy depends on her ability to pass through costs to her customers. If they are determined to purchase exotic confectionery, this may not be a large problem. The nature of the product is somewhat protected from a price increase as these candies are a luxury and not a staple like rice or beans.

As such, Nancy’s more visible risks are likely related to ensuring her supply and existing operation. Much of this stems from her being relatively undiversified with one store and one major supplier. If her shipping company is disrupted, her lease expires and cannot be renegotiated on good terms or her employees go on strike, she cannot service her customers.

Case Study 2: Big Nancy’s Candy Empire Discount Rate

Let’s say that the previous business described was representative of when Nancy just started in the candy business in 1990. Fast forward to today and Nancy has expanded to over 300 stores across several countries.

The risk profile has changed – now, Nancy has ample buying power as one of Glico’s largest direct customers. She can push for wholesale discounts, with the threat of going to Lotte or another substitute should Glico be unresponsive. Nancy will also have a more flexible supply chain with multiple stores to ship to.

On the operations side, a supply disruption would not cripple the business as there will still be hundreds of stores in operation. At this point, Nancy will have a good understanding of the real estate market and may have a dedicated leasing team to minimize rents.

We can expect the discount rate now to be lower than what it was before as the cash flows are inherently less risky.

If there are two companies operating in the same business, their values may still be very different depending on their cost structure and their leverage.

For US-listed public companies, it is required disclosure in their regulatory filings to have a section speaking to Risk Factors. Due to the litigious nature of the United States, companies can be very thorough in listing potential risks to cover all their bases – to the point where some are quite esoteric and not relevant to prudent investors. While the public filings may be a good place to start, investors may need to segregate real risks from more superfluous content and identify risks that may have been missed by the company.

The Business Moat

A moat is a body of water around a castle to make it more difficult to attack. In investing, a moat is how well protected a business is from competitive forces. A moat is associated with having a monopoly on a certain product and accordingly strong pricing power. Figuring out whether or not a company actually has a moat determines the true margin of safety on its value.

Two examples illustrate the moat concept quite well. Apple has enjoyed a dominant position with mobile hardware, consistently beating expectations for profitability and maintaining very strong operating margins due to their stellar brand and tight supply chain. However, Apple gets a majority of its profits from iPhone sales, which means that any decline in iPhone sales will mean a decline in profitability and valuation. The fear of other brands taking market share is what has traditionally kept Apple’s trading multiples low compared to other major technology companies that are often in the news – Amazon, Google and Microsoft.

As popular as iOS is and a certain number of the Apple fandom vowing never to switch, to some extent investors have seen similar collapses across other phone manufacturers that enjoyed strong market share – Nokia, Ericsson and Blackberry have all fallen on harder times since their tenures as king of the cell phone jungle. Apple too begins to see competition from previously unknown brands such as Oppo, Vivo, OnePlus (all three are owned by BBK Electronics), Huawei, Xiaomi and Google (having purchased HTC to manufacture their Pixel phone as they move into hardware). Apple has already lost its market leader position in several countries and may see declining margins as the upstarts build brand equity.

Conversely, a company such as Microsoft has an impenetrable moat. Across the business world, Microsoft Office is ubiquitous – practically every company uses PowerPoint for presentations, Excel for spreadsheets and Word for word processing. Even if companies build a better platform, which Google has attempted to do via Google Docs – it is impossible for Microsoft’s lock on office software to be broken as clients will all use Office. This is not to say that this cannot change eventually, but for the time being these cash flows are seemingly safe.

It is difficult to find moats as strong as Microsoft – however, a good analyst will look at other examples where a company has a stranglehold on a service and enjoys strong pricing power. Software and digital service companies are often the easiest to understand because if they capture a niche space, there are not a lot of variable costs (the marginal cost of implementing is close to zero) so they can scale quickly.

An example that we thought of is Live Nation. Every time someone purchases a ticket to a concert or a sporting event, they will almost always end up on Ticketmaster. The ticket itself is expensive, but buyers will find that there are plenty of exorbitant fees that push the ticket far above face value (such as a $20 service charge) – sometimes a large percentage of the original price. However, purchasers cannot do anything about it because practically all tickets have to be purchased through Ticketmaster.

Identifying a strong business moat does not mean that an investor can pay any price for the security – the rules of valuation still apply. However, in finding an undervalued stock or bond with a business moat, an investor can be relatively assured of the cash flows.

Secular Industry Trends and Avoiding Declining Sectors

The composition of major stock indices has changed substantially over the years. The world is always changing and change comes the fastest in the business world. The business moat needs to be re-evaluated as new technologies develop and consumer tendencies change.

For instance, newspapers were desirable media companies at one point with strong subscriptions leading to recurring cash flows. Now, regional papers have lost relevance and news is increasingly distributed by a few global players for free. The advertising landscape has shifted drastically and the value of newsprint companies has fallen.

A more recent example is the demise of the retailer. Another industry that was seen as a cash cow with consistent profits, retailers were good candidates for large debt loads because servicing interest was not seen to be a problem. Online shopping has changed the landscape and those debt loads have become excessive as retailers cannot compete with a middleman that has little overhead, centralized warehousing, lower labor costs and vast data analytics platforms.

Outside of public companies, a declining business is the traditional taxi cab due to ridesharing platforms such as Uber and Lyft. On a recent business trip to Calgary, an Uber driver mentioned that prior to Uber’s arrival, taxi medallions sold for $75,000. Now, no one will buy it for $20,000 and many taxi drivers have quit to drive an Uber.

Identifying disruptive forces early is key – from there, it is important to consider who it will impact and to what extent. This is not an easy exercise – for instance, the rise of Tesla and the Electric Vehicle have been lauded as the death of combustible engine transportation. However, does this mean the end of oil? There are a lot of end uses for a barrel of oil – petrochemicals and kerosene (jet fuel) are not seeing replacements anytime soon, so to what extent does this hurt an energy company? Are they being unfairly discounted?

Nancy may have the largest candy empire in the world, but if the global consumer trends towards health an investor has to have a view on whether or not Nancy can shift her product mix successfully against incumbents in the health space. If not, the intrinsic value of the business may decline.

Stock Investing Conclusions

The investment decision to purchase a stock is based on whether it is above or below its intrinsic value. If the stock is above its intrinsic value, it makes sense

Does it make sense to purchase a security at what we perceive to be its fair value given our discounting assumptions? The answer is that it depends. If we have valued the company prudently and assuming that it will continue as an operating business and grow, our capital should theoretically increase next year in accordance with an acceptable return on capital – however, this does not protect us from downside protection if adverse circumstances arise.

¹ (but excluding certain elements, such as the CAPM and multifactor models)

²but we may consider the economy, which the stock market is somewhat a proxy for.