Potential investors would do well to disregard the Hollywood trope of Wall Street traders looking at multiple screens and placing buy and sell trades across several securities at a frenetic pace, and thinking that making random bets is the way to go. Instead, they could look to Warren Buffet's guru Benjamin Graham's method of investing in bonds and apply it to stocks as well.
Typically, bond investments mean well-defined returns, and one needs to only worry about the risks. The focus in bond investing is on the credit rating, which is based on the fundamentals of the company issuing the instruments. The bond investor faces two risks: that of not receiving the interest coupon during the holding period and the risk of not receiving the principal at maturity.
Most people lose money in equities due to the same reasons people lose money in bonds. If the company goes out of business, then even the equity holders are wiped out. If one avoids such companies, one could be ahead of the market indexes which include these companies as constituents, thus generating alpha.
According to Graham, “The theoretically correct procedure for bond investment, therefore, is first to select a company meeting every test of strength and soundness, and then to purchase its highest yielding obligation, which would usually mean its junior rather than its first-lien bonds.”
Extending this logic further, the potentially even higher-yielding obligations are the stocks of the same company. Of course, one must pay attention to the valuations but at the right valuation, such a company’s shares would be a “safe” investment from a fundamental risk point of view, if its bonds are also “safe”. Then, the equity investor needs to only focus on the valuation risk, i.e., overpaying for the company.
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What are these principles of bond investing that can be applied to equity investing?
I. Safety is measured not by specific lien or other contractual rights but by the ability of the issuer to meet all of its obligations.
The issuer needs to service the interest as well as repay the debt. If the company has this ability, the bond investment is safe. So if the bond investment is safe, the holders of shares in the company too are safe from the risk of bankruptcy.
II. This ability should be measured under conditions of depression rather than prosperity.
To measure the ability of servicing interest and repaying debt under conditions of depression means evaluating the company's prospects when the company’s revenues, earnings and cash flows are significantly lower than in normal years. Ideally, the company should have the ability to service the debt even under those conditions.
III. Deficient safety cannot be compensated for by an abnormally high coupon rate.
If the principal is unsafe, a seemingly high interest coupon cannot compensate since it will still be less than the principal and the interest payment is also not assured.
IV. The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those prescribed by statute to govern investments of savings banks.
The idea is to exclude companies that are not safe and the remaining investment universe, consequently, becomes safer.
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Let's combine all the above and apply to equities selection. The process would be as follows:
First, study the historical cash flows and earnings of the companies under difficult conditions.
- Check if the company’s cash flows were sufficient to cover the interest costs during, say, the Covid pandemic and other cyclically bad years.
- Alternatively, check if the current cash flows or operating earnings are several times—four times or more—of its interest costs.
Second, check whether the company’s assets are greater than its debt outstanding.
Third, check how many years it would take for the company to repay its debt if they used all the free cash flow.
These can be applied numerically:
I. Cash flow to interest cover (use operating cash flow or OCF or earnings before interest and taxes or EBIT):
- OCF in bad year > 4 x current interest costs (especially for cyclical companies); or
- OCF in current year > 4 x interest costs (for growing companies)
II. Assets to debt cover:
- Total assets > debt; or
- Debt/equity < 50%
III. Cash flow to repay debt:
- Debt/OCF < 3
Under these conditions, the company is fundamentally safe with low business risk.
If one understands these secrets from the Graham and Buffett investment playbook, one is way ahead of the rest of the market. This step is the first foundation of the scientific investing framework, where we eliminate the Capital Destroyers. Beyond this one needs to avoid the Capital Eroders and the Capital Imploders, and then focus on the growth vectors the company is exposed to. Those steps will be explained in future articles.
But we will give here a quick hack to safeguard from Capital Imploders. For this, typically, one should stick to a maximum PE ratio of 35, ideally 25 or lower even for growth companies and PE of 15-20 or lower for slower-growing companies.
To invest like you would in bonds, let us remember the following words from Graham and apply it to stocks: “Bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance.”
The writer is CEO and chief investment strategist, OmniScience Capital.
Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.
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