Lessons from – “The Five Rules for Successful Stock Investing” by Pat Dorsey.


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Lessons from – “The Five Rules for Successful Stock Investing” by Pat Dorsey.

by Adib Motiwala

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 of accounting 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 are often best investments ( think contrarian)

Chapter 1 · Core principles of investing
o Doing your homework
o Finding companies with strong competitive advantages
o Having a margin of safety
o Holding for the long term
o Knowing when to sell

Chapter 2 · What mistakes 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, need to investigate
o ROE is a good measure of profitability but check the leverage levels that can make ROE look better.
o Be wary of companies with too much financial leverage

Chapter 7: Management evaluation · Checklist to evaluate management
o Compensation information from the proxy statement. 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. Look for executives that have substantial stock ownership positions.

Chapter 8: Avoiding financial Fakery
Six red flags
1. Declining cash from operations even as net income increases or cash from operations increases slowly compared to net income
2. Firms that take frequent one-time charges and write-downs.
3. Serial acquirers
4. CFO or Auditor leaves the company.
5. If A/R increases rapidly compared to sales. If sales go up by 10% and A/R by 20%, the company is booking sales faster than its receiving cash from customers. Also, watch for “allowance for doubtful accounts”. 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 plan from net income.
o Cash flow due to options exercise by employees
o Inventories rising faster than sales
o Changes in accounting assumptions such as depreciation expenses, allowance for doubtful accounts, revenue recognition,expense recognition.
o Capitalizing costs such as marketing and software 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 tangible assets. Least useful for service oriented firms.
· P/E can be compared to the market, similar firm or firm’s historical P/E ( most reliable)
· Use PEG with caution.
· Lowest P/E isn’t always the best. Prefer low risk stable firm that produces good FCF than paying less for a cyclical company that is very capital intensive.

Chapter 11: Worth the price of the book. 
Complete analysis on two companies based on everything in the book ( moat, financial statement analysis, management and company analysis, valuation and DCF)

Chapter 12: 10 Minute test
Here Dorsey proposes a list of question to ask of any company so that we can eliminate the poor investment candidates from the good ones really fast.
1. Min quality hurdle
    a. Avoid IPOs and avoid companies that trade on pink sheets and micro caps.
2. Has the company ever made an operating profit?
3. Does the company generate consistent cash flow from operations?
4. Is ROE consistently over 10% with reasonable leverage?
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 increased markedly over the past several years?

Beyond 10 minutes
· Look at 10 year summary financial statements.
· Read the latest 10-K filing front to back.
o Company, industry, risks, competition, legal issues, MDA, loans, guarantees, contractual obligations.
o Read two most recent proxies DEF-14A. Look for reasonable 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 what to look for in those companies, valuation, etc.
This is excellent material and a good way to learn about the different industries, how to understand them, what makes them tick, what are ways to value them.

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