Lessons from – “The five rules for successful stock investing” by Pat Dorsey.

Pat Dorsey is the Director of Stock Analysis at Morningstar.
·        Picking individual stocks requires hard work,discipline and an investment of time (and money)
·        You need patience, an understanding ofaccounting and competitive strategy and a healthy dose of skepticism
·        Buying stock means part ownership in a business
·        Courage of conviction
·        Companies with most conflict of opinion areoften best investments ( think contrarian)
Chapter 1
·        Coreprinciples of investing
o  Doing your homework
o  Finding companies with strong competitiveadvantages
o  Having a margin of safety
o  Holding for the long term
o  Knowing when to sell
Chapter 2
·        Whatmistakes to avoid
o  Swinging for the fences
o  Believing its different this time.
o  Falling in love with products
o  Panicking when the market is down
o  Trying to time the market
o  Ignoring valuation
o  Relying on earnings for the whole story
Chapter 3 Moats
o  Firms that earn high profits.
o  Focus on FCF, net margins, ROE and ROA
o  Source of moat
§ Product differentiation
§ Driving costs down
§ High switching costs for customers
§ High barriers to entry for competitors
o  Moats have depth (how much money can be made)and width ( how long can they sustain it)
Chapter 6: Company analysis
·        Checklist to analyze a company
o  Can growth be sustained over time? Source of growth
o  Growth via acquisition is not sustainable,usually acquisitions don’t produce returns for shareholders of acquiring firm,difficult to evaluate true growth rate
o  If Earnings growth outstrips sales growth, needto investigate
o  ROE is a good measure of profitability but checkthe leverage levels that can make ROE look better.
o  Be wary of companies with too much financialleverage
Chapter 7: Management evaluation
·        Checklist to evaluate management
o  Compensation information from the proxystatement. Does pay vary with firms performance.  Check pay package.
o  Avoid companies that give loans to executives,have many related party transactions or give out too many stock options. Lookfor executives that have substantial stock ownership positions.
Chapter 8: Avoiding financial Fakery
Six red flags
1.      Declining cash from operations even as netincome increases or cash from operations increases slowly compared to netincome
2.      Firms that take frequent one-time charges andwrite-downs.
3.      Serial acquirers
4.      CFO or Auditor leaves the company.
5.      If A/R increases rapidly compared to sales. Ifsales go up by 10% and A/R by 20%, the company is booking sales faster than itsreceiving cash from customers. Also, watch for “allowance for doubtfulaccounts”. This should move up in sync with A/R.
6.      Changes in credit terms and accounts receivable.
Seven pitfalls to watch out for:
o  Gains from investments recorded as revenue
o  Underfunded Pension plan
o  Pension padding : Subtract gains on pension planfrom net income.
o  Cash flow due to options exercise by employees
o  Inventories rising faster than sales
o  Changes in accounting assumptions such asdepreciation expenses, allowance for doubtful accounts, revenue recognition,expense recognition.
o  Capitalizing costs such as marketing andsoftware development.
Chapter 9: Valuation
·        Buy undervalued relative to earnings potential
·        Don’t rely on a single valuation metric
·        If firm is cyclical or spotty earnings history,use P/S
·        P/B used for financial firms and with tangibleassets. Least useful for service oriented firms.
·        P/E can be compared to the market, similar  firm or firm’s historical P/E ( mostreliable)
·        Use PEG with caution.
·        Lowest P/E isn’t always the best. Prefer lowrisk stable firm that produces good FCF than paying less for a cyclical companythat is very capital intensive.
Chapter 11: Worth the price of the book.  Complete analysis on two companies based oneverything in the book ( moat, financial statement analysis, management andcompany analysis, valuation and DCF)
Chapter 12: 10 Minute test
Here Dorsey proposes a list of question to ask of anycompany so that we can eliminate the poor investment candidates from the goodones really fast.
1.      Min quality hurdle
a.      Avoid IPOs and avoid companies that trade onpink sheets and micro caps.         
2.      Has the company ever made an operating profit?
3.      Does the company generate consistent cash flowfrom operations?
4.      Is ROE consistently over 10% with reasonableleverage?
5.      Is earnings growth consistent or erratic?
6.      How clean is the balance sheet?
a.      If D/E is greater than 1,
                                                              i.     Is the firm in a stable business?
                                                            ii.     Has debt been going down or up as a % of  total assets
                                                           iii.     Do you understand the debt?
7.      Does the firm generate FCF?
8.      Are there many one-time charges?
9.      Has the number of shares outstanding increasedmarkedly over the past several years?
Beyond 10 minutes
·        Look at 10 year summary financial statements.
·        Read  thelatest 10-K filing front to back.
o  Company, industry, risks, competition, legalissues, MDA, loans, guarantees, contractual obligations.
o  Read two most recent proxies DEF-14A. Look forreasonable compensation and options granting policy.
o  Read last 3 annual reports.
o  Look at two most recent 10-Q filings.
o  Start valuation of the stock.
Chapter 13 – 26 : Covers  major industries and whatto look for in those companies, valuation, etc.
This is excellent material and a good way to learn about thedifferent industries, how to understand them, what makes them tick, what areways to value them.


About Adib Motiwala

Portfolio Manager at Motiwala Capital LLC
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