Posts in category: Concepts

Here I refer to the core portfolio as the portfolio of stocks which you have carefully done your homework through PhD Fundamental Analysis and you would be holding for quite some time to reap the benefits of capital appreciation. Below is a sample portfolio. How many stocks should you hold? What is a good number?

Well, this is not an exact Science but if there are too many stocks, you might as well consider investing in an Exchange Traded Fund (ETF). Also, if there are too many stocks, it may be too taxing on you as an individual investor as the amount of research work required may be too daunting.

To me, a good number is probably between 10 to 15. This number provides a good diversification strategy across companies and industry sectors and it is manageable for a retail investor. If you are just starting out, there is no need to rush through the process of building up your portfolio. I believe it is more important to thoroughly discover and research wonderful companies and the efforts you put in will be translated into great profits later.

The other thing that I recommend is to slowly buy up the number of shares for each stock in your portfolio according to the dollar budget that you have planned and set aside, unless of course there is a rare situation the said stock is in huge discount to its intrinsic value for whatever reason. Stock prices move up and down in the shorter term for no particular reasons, according to the whims and fancies of Mr Market, therefore it may also pay to adopt Dollar Cost Averaging.

I like to keep abreast of the developments around a stock that I own in my core portfolio. You should catch up with companies’ quarterly or half-yearly earnings updates to ensure that the business fundamentals remain intact and to see if assumptions made in the intrinsic value calculation made during the Valuation step are still valid. Sometimes, you may need to take some “buy more” or sell decisions if conditions have changed, positively or negatively.

To help me understand more about my portfolio stocks along the way, I leverage on Google Alerts which you can set up through any Gmail account.

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett

This is one of the quotes by Warren Buffett that I like a lot. It took me some time to internalize this and fully understand the meaning behind and it is perhaps best explained through the following picture:

We have defined wonderful companies as companies that pass our PhD (Profitability, Financial Health & Growth Drivers) benchmark criteria, meaning they have good profits for a long period of time, they have a great financial health as reflected on their sound balance sheet and they continue to possess drivers to grow.

We have explained margin of safety and once you have calculated the intrinsic value of a company, always look for entry points where the price is below the value. When you buy a wonderful company, every year it is making good profits and the intrinsic value is expected to grow over time, as depicted in this picture.

Let us look at the entry point with the small red circle. Unfortunately, some shares of the company are bought when it is over-valued, perhaps due to some over optimistic assumption made during the valuation step. The situation is not too bad at all if this company you invest in is a wonderful company. The value of the company rises over time and soon the share price catches up and you will be in profit if you are a long-term investor.

This learning has influenced my investment philosophy a great deal and nowadays I only look for wonderful companies and invest for the long term. When a company continues to build up its intrinsic value, time is on your side and the longer you hold, the higher the potential capital appreciation.

Some of us have heard or learned about Peter Lynch’s PEG valuation formula but many of us probably took the formula at face value, at least that was what I was told when I was taught the formula. To recap for all, Peter Lynch is a famous fund manager and author of One Up on Wall Street and he proposed the PEG valuation model, especially for growth companies. The formula relates to a company’s PE ratio and its growth rate and is computed by taking the PE ratio divided by the company’s EPS (earnings per share) growth rate:

PE ratio / Growth Rate

> 1 implies overvalued

< 1 implies undervalued

Do you use the PEG formula as a valuation method? Is there a mathematical proof of the formula? Well, we will relate this to another valuation model which many of us are familiar with as well, the discounted cash-flow (DCF) model. Here, instead of using cash-flow, I will use EPS instead.

Let’s compute the intrinsic value of a company growing at various rates, from 10% to 25%. I am going to assume the company continues this good growth range for the next 10 years to derive the growth value and the terminal value is computed by discounting for a further 10 years of 4% growth rate. In addition, we take the discount rate as 15% and assume the initial EPS is $1. [Note: some people would suggest that you compute the company’s Weighted Average Cost of Capital WACC for the discount rate but really, save your time and use your expected rate of return for this figure]

It turns out that Peter Lynch’s formula is a good proxy to the DCF model. If a company is growing at 20% and the PE ratio is 20, it is about fairly valued. If the company is growing at 15% and the PE ratio is 15, it is about fairly valued. And so on.

In this illustration, we have not factored in Margin of Safety (MOS) which is prudent to include. The discount rate of 15% is used in this calculation; it should be noted however that the discount rate should be related to the market interest rate environment, which is relatively low now. If a lower discount rate of say 12% is used, the PEG formula may seem conservative.

I love the PEG formula as a very quick and easy filter for me to do a first cut valuation of any particular growth stock, whether I should put it in my watch list or some immediate investment decision may be made. I will then switch over to the DCF model as it provides me the flexibility of changing the various parameters to assess best case and worst case scenarios and the risk-reward ratios.

I hope that you know now that there is a basis to Peter Lynch PEG formula! It is still relevant to use but do take note of the interest rate environment we are in, whether the formula may be too conservative or not.