What is the best time to buy shares for investing?
We often hear “Buy low and sell high”.
True, but what does "low" in mean?
From an investing point of view:
Buying low does not refer to when the share price is near the 52 week low or 10 year lows.
Low means that the intrinsic value of the company far exceeds the market capitalization (price) of the company.
Estimating the intrinsic value
The starting point of any investment is to calculate the intrinsic value and requires reading annual reports, understanding the assets and liabilities, cash flows and profits history. You need to know how the company makes money.
The company's profits need to be examined for items that are irregular and will not persist going forward.
If a company is disposing of a segment I need to go back to prior year profits and remove that segments profits from the company's total.
I will then typically calculate the average profits for the past 10-15 years.
The maximum intrinsic value I’m willing to work with is 10x average earnings.
When you buy the shares of any company,
No matter how small your shareholding,
You are in effect buying a piece of the assets, liabilities, management, skills of staff and operations.
The balance sheet (or statement of financial position) of a company records most of the assets of the company.
Some assets like internally-generated brand names are not recorded on the balance sheet as per the accounting rules.
All assets should be judged on what they produce.
That a company has a great brand should not be a justification for paying a high price for its shares.
A great brand should first show its worth by producing the income.
The income statement (statement of profit or loss) of a company shows how much earnings the combination of management, staff, assets and liabilities can produce.
This is then used to calculate the intrinsic value of the business.
When you buy shares (little pieces of a business),
it is not always a like-for-like exchange.
Sometimes you can overpay and sometimes you underpay.
Price is what you pay,
Value (the share of the business) is what you are getting.
The art of investing prides itself on buying securities that are undervalued by the market
always underpaying by having a margin of safety.
Different shares get undervalued for different reasons:
The industry is not exciting enough, has been making losses for some time...
Take for example today:
The most sought-over stocks are tech giants and internet services like Uber.
These companies are trading at high earnings multiples because of their tends of rising growth in earnings in recent years.
Much more established industries like vehicle manufacturers (except Tesla) are trading at lower earnings multiples for the fact that they have reached maturity, growth is slow and that in 10 years time we will all have electric cars.
The concept of margin of safety is easy to understand.
Margin of safety is the excess of the intrinsic value of a business over its market capitalization
(Intrinsic value less market capitalization= margin of safety if positive).
Investments are made only when the margin of safety is large enough, say 50% above the market capitalization.
As people,
It is easy to get very excited about an investment opportunity that we forget to ask the vital questions of “how much is it ?” and “what is its intrinsic value?” before making a purchase that we most likely end up overpaying.
Margin of safety acts as a room for error in estimating the intrinsic value of a company.
Margin of safety in action:
Santova logistics (SNV) provides cross-border logistics and customs clearing services.
Its market capitalization is currently hovering between R220-280 million on the JSE.
Santova does not own many of the assets to conducts its trade,
Rather the company makes use of other cross-border logistics companies such as DHL and others, and makes use of their assets.
The annual reports indicate that the company can on average generate about R50 million net in cash profits.
Santova’s balance sheet appears strong in that current assets cover total liabilities.
Santova has over the years acquired businesses that, among them UK-based W.M. Shipping Limited in 2013, have built its accounting profit generating ability to approx. R50 million a year.
Using an earnings multiplier of 8x on the company, I placed an intrinsic value of R400 million on the company.
Hence
At the market capitalization of R240 million,
I was very happy to buy into the company when it was trading at a 40% discount to what I valued it at.
A R50 million annual profit means that the company is generating a 21% annual return on the price level I paid.
I am very happy that the investment will be earning a very high return.
That the company’s market capitalization may rise to R400 million is the least of my concern.
Not all purchases of shares are investments.
Merely hoping that the share price goes up without considering the underlying business is pure speculating
I personally have a problem with modern investing:
There is a willingness to purchase assets at any price level
Prosus, so hell-bent on building the world’s leading food delivery business,
want to acquire UK-listed Just Eat for R93 billion.
Just Eat's highest profit to date is R1.5 billion in 2018.
This in effect is a 1.6% return on investment.
In my opinion Prosus is overpaying.
The Efficient market theory (EMT) holds that there is a direct relationship between risk and return:
The higher the risk associated with an investment, the greater the return.
We value investors however see things oppositely,
I was taught that not all price levels are acceptable to make purchases.
The higher the price of any asset, the riskier the investment becomes.
Therefore for assets that have been undervalued by the market,
These should carry lower risk and have potential to produce high returns.
We do not buy into....
For investors
We only purchase when the price is right i.e
When the intrinsic value of the share exceeds its market value.
I personally like companies that are selling at a 50% discount to their intrinsic value.
Japhta Mamalema
14/11/2019