Flipping a Stock versus Indefinite Ownership

Stock flipping? Why not just indefinitely own it to take
advantage of its underlying compounding power... forever?

On one hand, there's the strategy of appraising a stock and arriving at an intrinsic value. If the current market price is selling below this "fair" value, then it's a signal to purchase the stock. After acquiring some shares, the "investor" would be waiting for the market to correct itself and price the stock at the level of the intrinsic value. Upon its appreciation towards the fair level, the "investor" would then sell the stock to realize an immediate capital gain. It becomes a relentless pursuit, since liquidation forces one back to a cash position, which requires to identify yet again another bargain candidate to exploit.

Republic Cement as an Equity Bond with an Expanding Coupon

It's just a cement bag. No! For me, it's an equity bond with a powerful compounding/expanding coupon!

This is Part 2 of a Series. Go to Part 1: How to Quickly Assess a Likely Long-term Rate of Return Given a Stock’s Current Price

We turn ourselves to Republic Cement (PSE: RCM), a company I was able to purchase three years back then (and still holding) when it was still selling below book value.

Fast facts: It’s been in the business of manufacturing and selling cement for decades. It’s currently the market leader; majority holder is that worldwide leading French cement company called Lafarge. Catastrophe risk is almost minimal.

So let’s try to apply the simple appraisal steps noted earlier...

How to Quickly Assess a Likely Long-term Rate of Return Given a Stock’s Current Price

Foresight? In stocks, hindsight is clearer and easier. While we know by hindsight what the excellent business is capable of performing, we downplay our prospects of it, and content ourselves with the more likely, easily achievable, conservative scenario.

This is Part 1 of a Series.

I’m starting to be more inclined towards fast but very conservative approaches in rate of return and intrinsic value appraisals. Because no matter how detailed, elaborate, or complex our models are, if the assumptions, programming, or the projections themselves are too optimistic and aggressive, then the likelihood of achieving these forecasts would be thinner. And the same thing goes with achieving superior returns.

What we simply want to do is downplay our prospects, minimize our expectations, and be happy and content ourselves with the safe, very achievable, conservative scenario, and pay a reasonable price for that—all these despite knowing by hindsight that the business is much more capable and can offer more!

Capital Preservation and Rational Potency of Earnings

This is Part 2 of a Series. Go to Part 1: On Discount Rates, Required Rate of Return, and Conservative Purchase Price.

The idea behind capital preservation is defensively allocating capital in a safe investment position (thus, preserving your money’s worth) but at the same time exposing it to the prospect of profits (or capital gains)—Simply, it is earning without risking losing money. The cardinal concern shouldn’t really be profits—it should first be preserving capital. Profits only come secondary after making sure we don’t lose money. If we start concerning ourselves on this primary consideration, then we’d undoubtedly be diligent and be very cautious in our allocations.

Earning without risking losing money. Capital preservation should remain top priority, with earning profits only being an afterthought.

So if that be the case, then why not just easily opt to hold hard cash, you may think? Well that’s hardly the solution. Complacently leaving your cash lying in the room or under your bed or pillow would diminish its worth because of that value-sucking animal called inflation—the real enemy. Capital preservation is therefore achieved only through placements in value-enhancing instruments which, at the least, beats inflation.

In the realm of stocks, capital preservation can be ascertained by banking on very conservative assumptions of underlying value. Why underlying value? Because that can only be your best bet towards consistency and predictability. If you rely on market value, you’d be subjecting yourself to the whims, emotions, and ups-and-downs of the market. And that would certainly not preserve capital. (An aside though: take note that this is only true if we exempt arbitrage plays; in arbitrage scenarios, the pursuit of value is not found on the underlying business, but rather on the difference between prevailing market price and the publicly declared market tender offer—the arbitrageur viewing the discrepancy as his source of value gain). Nonetheless, certainty is key.

On Realizing Gains, Compounding Value, and Equity Perpetuity

This is Part 2 of a Series. Go to Part 1: On Price, Value, Value Investors, and Equity Perpetuity

The following are excerpts from a discourse I had with a fellow investor with regards to realizing gains, compounding value, and equity perpetuity. Let me stress that I don’t claim these constitute canon—these are just my own personal views.

Realizing profits versus compounding value. On one hand, the impulse and instant gratification of realizing profits ironically brings you back to that burden of finding another bargain; on the other, you may have just held onto that stock and let compounding do its magic.

On realizing profits: If the intention is to compound value and amass net worth (i.e. to be rich), then you wouldn't worry about not realizing capital gains. That's the irony in selling stocks—on one hand, by impulse, you just want to realize your paper profits. Realizing your capital gains, however, would again bring you back to that burdening position of finding another bargain (and exposes you to taxes) if you intend to reinvest and further create value. On the other, you may have just indefinitely held onto that stock as long as the underlying business takes care of itself (which in turn takes care of the price). And what is easier and which I personally prefer is the latter case wherein you let the value compound within the business, i.e. that's why I prefer non-paying dividend companies able to retain earnings and compound them at sustainable high rates than businesses paying out all their earnings in dividends (which again exposes you to taxes) at the expense of growth.

On Price, Value, Value Investors, and Equity Perpetuity

This is Part 1 of a Series

The following are excerpts from a discourse I had with a fellow investor with regards to future price projection, focusing on business value, and the usefulness/relevance of the equity perpetuity theory. Let me stress that I don’t claim these constitute canon—these are just my own personal views.

Value investors don't project price, they project value. It should always be some underlying value you're anticipating to get. The difference maybe subtle, even trivial, but in my view, crucial and vital.

The whole intent behind the equity perpetuity concept is to find a safe purchase price (for an excellent business) to achieve your required rate of return. The intention is not to project a target sell price or predict the market. The intention, primarily is capital preservation (through sound business/fundamental basis as represented by forecasted flat earnings/cash profits—you can never rely on market swings/movements to preserve capital anyway) and exposure to rational potency of earnings. And that's primarily the focus and intent of value investing.

Indeed, the principle of value investing is purchasing excellent businesses at bargain prices and not to forecast a future stock price or predict what the market will do. And that being the case, value investors are first and foremost, naturally conscious and very focused on not losing money (that's why all the fuzz on buying a bargain price)—that is, capital preservation—but with the added benefit of exposure to rational potency of earnings (i.e. because of buying into a defensive stock position with an underlying profitable business).

Anticipating a future stock price should never be explicit. Because once you start throwing off some stock price projection tool, the focus tends to be just that: market price forecasting. And there's the peril of neglect where value comes in the first place—the underlying business.

Rate of Return on Equity Perpetuity: Dividend Yield and Free Cash Flow Yield

This is Part 2 of a Series. Go to Part 1: Intrinsic Value and the Equity Perpetuity Theory

If we start to think of stocks as perpetuities (i.e. if we intend to be passively enriched as the "equity" perpetuity unendingly pays us flat dough—regardless what the market is schizophrenically doing) then we might as well identify which "equity" annual payments we’d be considering and discounting. Once we identify these, we'll discover that the rate of return on our equity perpetuity is nothing more than two familiar, often used (but also often misunderstood) measures: the dividend yield and free cash flow yield.

Return Measures of the Equity Perpetuity. When we conservatively assume a stock is a perpetuity and try to derive a rate of return, we're mathematically bound to eventually use the Dividend Yield and Free Cash Flow Yield.

If we choose cash dividend payments, then we’re effectively using the dividend yield. If a stock has recently paid out dividends of Php100 and we assume that it’s gonna issue dividends year after year (since it’s been doing that for years already) and we also assume these will be flat, then we'd have to discount Php100 at a rate we'd want to achieve (i.e. 15%). Using this conservative frame of mind, the stock, obviously, has got to be worth Php666.67 (Php100/15%). On a flipside, if the same stock’s trading at Php500 and we bought it at that price level, then perpetuity-wise (i.e. assuming flat payments forever), our rate of return shall conservatively be 20% (imagine: that is regardless whether the market shuts down or commits suicide—you’re just relying on the fundamental dividend-paying capacity of the underlying business). The dividend yield shall be that equity perpetuity yield from a dividend-conscious perspective. Isn't the Dividend Yield more meaningful if taken from a flat-dividend-paying perpetuity standpoint?

Intrinsic Value and the Equity Perpetuity Theory

This is Part 1 of a Series

Flat cash payments into infinity. To think of stocks as "equity" perpetuities can be a useful, conservative mindset to quickly assess a reasonable purchase price. Despite projecting perpetual annual cash payments, they're still assumed, nonetheless, flat!

Thanks to that contemplation on how relevant and useful the P/E Ratio and Earnings Yields are, I’ve been thinking about perpetuities often these days. And because of that, I’m starting to think of stocks as perpetuities. It’s reasonable, after all, if you intend to indefinitely hold on to an excellent business which would continuously and unendingly generate you bucks passively year after year after year (and beyond). And the great thing about perpetuities is that, they’re conservative! They’re conservative primarily because of their flat or fixed annual payments assumption. We do all know that a good company shall be able to expand or grow its cash profits year after year. So if we’re going to assume flat earnings, then that’s definitely being conservative, don’t you agree? To think of stocks as perpetuities shall be a conservative, appropriate mindset, for a prospecting, long-term rational investor conscious of a reasonable purchase price.

The Price-Value Breakeven Theory of Stock Investment

Introduction: In the early stages of my investing career, I tried to develop an independent way of thinking about stocks—my intention was to focus on the stock’s underlying business financials and utterly disregard how its price performed. The idea was to put myself in the shoes of a rational, long-term shareholder (and have the sort of pure mindset of an entrepreneur). The exercise led me to ponder on very basic but key financial concepts. Note that this is, admittedly, a very extreme, crude approach and wouldn’t seem practical. It has yet to consider cash flows and the time value of money. But I think it’s worth a review to touch base with our business mind or entrepreneurial psyche when dealing with stock investments...

From a purely business perspective, the moment you buy a stock, what you immediately possess as a part owner or stockholder of that business is its current net worth, its equity, or book value. In addition to its present net worth, you also possess its earnings potential which is realized in the future. Premium is therefore understandable, but not to such extent it already escapes rational potency of earnings. Overpricing risks permanent loss of capital.

Taking a feasibility and payback approach to stock investment, this valuation theory treats the buy price of a stock as an initial outlay. The investor, stoic to market price fluctuations upon entry, therefore, takes on the conservative position of eventually breaking even when book value per share, through comprehensive earnings and stock dilution/accretion gains, overtakes price. Upon breakeven, the investor’s rate of return approximates the Return on Equity (ROE).