A value investing guide for the Sri Lankan stock market investor

An article on how a Sri Lankan stock market investor can apply a risk-averse long-term value investing approach when making an investment in the Sri Lankan stock market.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” — Ben Graham

Introduction

“Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.” — Joel Greenblatt, The Little Book That Beats The Market

As daily turnover for the Colombo Stock market reached historically high levels earlier this year, were participants really investing? Or speculating?

In this article, I’m going to make the case for why each investor ought to understand the difference between speculation and investment, and how one can use a long-term value investing approach to make investment decisions.

This article will cover the following:

1. Why is speculation a form of gambling?
2. What is value investing?
3. How can you apply value investing in Sri Lanka?

Speculation

1. Why is speculation a form of gambling?

“When enterprise becomes the bubble on a whirlpool of speculation . . . [and] when the stock market takes on the attitude of a casino, the job [of capitalism] is likely to be ill-done.” — John Maynard Keynes

A common way to gauge what people expect out of participating in a stock market is to find out what they define as investing. So how do most people approach investing in the Colombo Stock Exchange?

My observations lead me to conclude that many of these market participants treat stocks as pieces of paper that can be traded around. The value of that paper being determined by an expectation of what the next person is willing to pay for it. Hence, their entire focus seems to be on what the price of this paper is going to do. This is not an intelligent way to think about investing and is more akin to gambling.

There are many modes of thought on this, however, I think the right way to think about investing in the stock market is tackled below.

“The burnt customer certainly prefers to believe that he has been robbed rather than that he has been a fool on the advice of fools.” — Fred Schwed Jr, Where are the customer’s yachts

Value investing

2. What is value investing?

“For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope of consistent success as an investor is just that: hope.” —Howard Marks, The Most Important Thing

Investing is about laying out money today in order to get more money out in the future, more money in real terms, after taking inflation into account. I’ve written more about this subject in an earlier article here.

But what is this concept of value in investing? And where does it come from?

Here’s a way to think about it. If you were to buy an income-generating asset, such as a farm, paddy field, estate, apartment, or house, how would you value it? You would likely value this asset by the stream of income you expect to generate from it, while also comparing it to the streams of income in assets of a similar nature, in order to draw a comparison.

Similarly, since a stock represents a fractional ownership stake of a business, if you think of yourself as a private business owner inquiring into the value of a business, you define the value of a business the following way:

Value investing in the Sri Lankan stock market is about buying an ownership stake in a business that produces cash for you as an owner. To begin, you need to be able to value the business and discount the cash flows you will receive over its lifetime. Then, in order to intelligently invest, you must be able to buy that business at a discount to that intrinsic value, taking into account the alternatives available to you at that time.

This is value investing, as the father of modern security analysis Ben Graham defined it. All other operations are speculative. This article will not go any further into speculation. As gambling is neither intelligent nor profitable, we will move on to applying value investing to the Sri Lankan stock market.

So how do you really apply this to the Sri Lankan stock market?

A value investing guide

3. How can you apply value investing in Sri Lanka?

“All intelligent investing is value investing — acquiring more than you are paying for. You must value the business in order to value the stock.” — Charlie Munger

You’ve got to value the stream of income from the business

In the example below, I’m going to show you how to value a simple business. The simple assumptions made below are for the purposes of illustrating the example.

Step 1: Learning to value Dias and Son’s Corner Shop

Let’s say you live in the suburbs of Colombo, Mr. Dias is a businessman who owns a corner shop at the top of your lane. It has a recurring customer base in a great location. His booming business sells everything from bubble gum to newspapers and soft drinks. Now he wants to sell the business (to make this simple let’s say he doesn’t own the land and has locked in a 10-year long-term lease with the landowner). He approaches your dad (sorry, he still thinks of you as a kid even though you insist on being treated as an adult) and names a price of Rs. 10 million. So how do you know if your dad is making an intelligent investment? How do you find out the value of Mr. Dias’s corner shop?

The value of a business comes from how much that business earns over its entire lifetime. We begin by thinking about the income this corner shop will generate over the next 10 years. We’ll assume, for the purposes of this example that the business will generate a profit after-tax income of Rs. 1,000,000 each year. And we will assume it continues to produce this each year for the next 10 years.

We know that collecting Rs.1,000,000 each year for the next 10 years is not the same as receiving all Rs. 10,000,000 today. If we had that Rs. 10,000,000 at this moment, we could easily put it in the bank and then earn some interest on our deposit. Many large banks would be happy to provide us with deposits that would pay us well over 7% a year for the next 5 – 10 years.

By the time 10 years go by, we’d have a lot more than the original Rs. 10,000,000 from all the interest we collected. But, of course, Mr. Dias’s corner shop only earns Rs.1,000,000 each year, and we’ll have to wait 10 years to collect all that Rs. 10,00,000.

So let’s break it down and see what 10-plus years of earning Rs. 1,000,000 per year are really worth to us today.

Here is how the math works out: Rs. 1,000,000 one year from now discounted by the 7% we didn’t get to earn is Rs. 1,000,000 ÷ 1.07, which equals Rs. 934,579 (Another way to look at it: if you had Rs. 934,579 today and deposited it in the bank at 7%, you would have Rs. 1,000,000 at the end of one year). Similarly, the following table maps out what this would look like over 10 years.

The present value of 10 year’s worth of earnings at a 7% discount rate (source: link).

So earning Rs. 1,000,000 a year for the next 10 years turns out to be worth in total about Rs. 7,023,582 today.

Using these simple assumptions, we just figured out something incredibly important. If our investment outlook is a period of 10 years, at the current fixed deposit rate of 7%, Dias & Sons, a business guaranteed to earn us Rs. 1,000,000 a year for the next 10 years is worth about Rs. 7,023,582 in cash today.

Step 2: Does the purchase price make sense?

Here comes the hard part. So Mr. Dias initially offered us the business at Rs. 10,000,000. Does this make sense? At first glance, this does not make a lot of sense given that we valued the business at roughly Rs. 7,000,000. That isn’t the end of the story though.

What if Mr. Dias offered the business at Rs. 5,000,000? Yes! This is obviously a better deal. Now you earn 20% per year on your investment (Rs. 1 million of profit per year / the Rs. 5 million purchase * 100). This far outweighs what you can earn at the bank. This is a real discount to the value we calculated for the business and hence makes a lot of sense.

This is the essence of value investing. The idea is to figure out the value of something and then — pay a lot less! In fact, it couldn’t be simpler: Rs. 7,023,582 is a lot more than Rs. 5,000,000.

Step 3: Is it really this easy?

No chance! It is never this easy and it is rarely if ever this straightforward. First, I began with the assumption that earnings will be the same over a 10 year period. In reality, predicting earnings for a business over the long term accurately is a very difficult thing to do. Small changes in the discount rate or the growth rate of earnings can have a huge difference in the value we end up with!

Additionally, I’ve simplified the business for this example, but in reality, a corner store has its own micro-economics at play. What if the business stocks items that are disrupted by technology? What if a convenience store opens across the street that offers lower prices? In other words, there are factors at play that could cause the business to deteriorate or grow over time. So you can not just assume earnings are going to be the same over the long term unless you are really sure.

So this is a large problem. We should always remember that our estimate of earnings, is just that: an estimate. There is a chance that we can be wrong or correct, sometimes by a lot, sometimes by a little. This is why Ben Graham formulated the ‘margin of safety’ principle in chapter 20 of his book ‘The Intelligent Investor’. This must be the basis of every investment. You can read more about it by buying the book here or read about my review of the book here.

So how do we apply this to the Sri Lankan stock market?

Here is where it gets very difficult. The principles discussed above are simple but far from easy to execute. This is further compounded by the complexity of modern publicly traded businesses in a modern economy and market system.

In a market system, businesses are constantly trying to get ahead of each other in order to serve customers. Technology makes the problem of understanding future cash flows even more uncertain.

You’ve got to be able to answer some very simple questions confidently in order to assume that your prediction of cash flows may hold out to be correct over the long term.

Here are just a few of those questions you may need to answer when trying to gauge the certainty of the discounted cash flows of a publicly-traded company:

• What is the right discount rate?
• Do you really understand the business? Does it grow over time? What are the chances it goes out of business?
• Does the business have a durable competitive advantage? Can competitors and other forces disrupt those cash flows?
• It is run by able management who cares about you (the shareholder)?
• What happens if your valuation turns out to be wrong? Are you adequately protected if the business faces headwinds?
• Is it for sale at an appropriate price? No business is worth an infinite price.

Conclusion

“It’s not supposed to be easy. Anyone who finds it easy is stupid.” — Charlie Munger

As you probably already figured out, intelligent investing is far from easy. The act of buying stock may be easy because of your broker, but it is not easy to derive a proper valuation for what it is you are buying. Value, however, is your indispensable starting point.

If you enjoyed what you read here, check out all my articles related to investing. Read a previous article on intelligent investing here or how my memo on how to understand a wonderful business here.

Additionally, check out my checklist on the psychology of human misjudgment (a guide that keeps in check psychological folly, inspired by the wit and wisdom of Charlie Munger) here, or my article on Ben Graham’s ‘The Intelligent Investor’ here.

You can find me on LinkedIn or contact me at https://www.chrisquyn.com/contact/

References

This article was derived in large part by the influence and inspiration listed below.

1. Benjamin Graham, The Intelligent Investor
2. Joel Greenblatt, The Big Secret for the Small Investor: The Shortest Route to Long-Term Investment Success
3. Howard Marks, The Most Important Thing: Uncommon Sense for the Thoughtful Investor
4. Lawrence A. Cunningham, The Essays of Warren Buffett: Lessons for Investors and Managers
5. Peter D. Kaufman, Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger, Expanded Third Edition