Duke Investment Club

Investment Fundamentals

September 26, 2010 - Henry Jiang

Agenda
Introduction to financial markets Stock selection process Pitching stock ideas Discussion and Q&A

Intro to Financial Markets

Why do financial markets exist?
Facilitate capital flows between economic units that save (e.g. households) and those that invest (e.g. businesses)

Types of financial markets

Money market Short-term debt instruments (maturity < 1 year) Capital Markets Longer-term financial instruments (debt and equity)

How do firms raise money?

Debt (bonds) Equity (stocks)

Stocks vs. Bonds

Difference between owning stocks and bonds
Bondholders = lenders Stockholders = owners

Definition of stock: A type of security that signifies ownership in a

corporation and represents a claim on part of the corporation's assets and earnings (common stock and preferred stock)

Definition of bond: A piece of debt instrument that signifies

lending to a corporation. Has priority over equity in the capital structure

How does the stock market work?

Companies issue shares to the public through an IPO Why do companies issue shares?
Raise capital to fund investment in their business

Shares traded on an exchange

NYSE, NASDAQ, AMEX, etc.

Benefits of an exchange:
Large volume Continuous prices Prices set by forces of supply and demand

Who trades stocks?

Institutional investors (mutual funds, hedge funds, pension funds, etc.) Individual investors (retail investors)

Investment Strategies
Technical analysis: Investors focus on price action and volume Usually used for short-term trades Chart reading Fundamental analysis (What we will focus on): Price vs. intrinsic value Analyze businesses Financial statement analysis Valuation Typically used for intermediate to long-term investments Other Considerations: Portfolio Allocation & Diversification Long / Short

Our Investment Philosophy

Broadly defined, we are value investors We do not chase momentum We do not buy based on chart patterns Growth is an important component of value; we look for growth at a reasonable price Long-term investment horizon (1-3 yr)

Low turnover conviction calls; trading costs

We try to invest in a diverse mix of companies Diversified across multiple sectors ranging from consumer retail to industrials to financials to technology, etc. Diversification spreads risks Market-cap agnostic size does not matter

Stock Selection Process

Goal: Buy a stock that will generate superior returns over the long run Remember: Attractive risk / reward profile The research process: Step 1: Picking a stock: where to start? Step 2: Understand the industry and business model
Qualitative and quantitative considerations

Step 3: Competitive environment and advantages Step 4: How much is it worth?

Is it worth it?

Step 1. Picking a stock: Where to start?

Start with things you know or industries that interest you (example: Buffetts sphere of competency) Top-down macro approach: look at sectors or industries Quantitative approach: stock screens HDFC Bank: We had no BRIC exposure in our portfolio Macroeconomic conditions and growth prospects in combination with Attractive valuation profile

Step 2. Learn the business

Where to look?
Companys investor relations webpage (very important resource) 10Ks, 10Qs (company website or Edgar at www.sec.gov) News: WSJ, Yahoo! Finance, Bloomberg, etc. Industry research (Datamonitor, S&P, trade publications, blogs, etc.) Wall Street analyst research (via Multex) S&P reports (via Fuqua library site)

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Qualitative Considerations
What does the company do? How do they make money (point of revenue generation)? Competitive advantages Who are their customers? Operating history Where will the business be in 5 years? What growth opportunities exist? What are the key risks? Management consistency and performance

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Quantitative Considerations
Financial statement analysis
Income statement Balance sheet Statement of cash flows

Ratio analysis Is it worth it?

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Important Metrics
Make sure you understand the industry-specific metrics and why they are important Earnings (bottom-line) growth Profitability Ratios Operating Margin Net Profit after SG&A / Net Sales Gross Profit Margin (Sales COGS) / Net Sales EBITDA Margin earnings before interest, taxes, depreciation and amortization / sales Return on Investment (ROI) Net Profit after Tax / Total Assets Return on Equity (ROE) Net Profit after taxes / Shareholder equity Earnings Per Share (EPS) <Can this be compared across companies?> (Net profit after taxes preferred stock dividends) / Average number of common shares

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Key Ratios (1 of 2)
Liquidity Ratios Current ratio Current assets / current liabilities Quick ratio (CA inventories) / CL Cash ratio (Cash + cash equivalents) / CL

Activity Ratios Inventory turnover Net sales / inventory Accounts receivable turnover Annual credit sales / accounts receivable

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Key Ratios (2 of 2)
Leverage Ratios Times interest earned (pretax profit + interest expense) / interest expense Debt to equity ratio Total debt / shareholder equity Debt to asset ratio Total debt / total assets Coverage Ratios Interest coverage EBITDA / interest expense Debt service coverage ratio (EBITDA capex) / (interest expense)

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Step 3. Competition
What is the companys competitive advantage? Is its business model easily replicable? What is its market share? How will it defend and grow its market share? How does its business (reflected by metrics) compare to its competitors? SWOT Analysis
Strengths Weaknesses Opportunities Threats Power over suppliers Power over buyers Threat of entrants Threat of substitutes Industry rivalry
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Porters Five Forces:

Step 4. Valuation
Comparative multiples P/E ratio; P/Sales ratio EBITDA multiples: EV/EBITDA Relative valuation Discounted cash flow analysis Intrinsic valuation Sum of parts analysis Leveraged buyout analysis Baseline valuation

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Questions?

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