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MagicDiligence (< 20)

Book Review: Why Are We So Clueless about the Stock Market?

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February 02, 2010 – Comments (1) | RELATED TICKERS: FNMA , FMCC , AIG

Are you clueless about the stock market? If so, or if you are not sure, Mariusz Skonieczny's book is for you. Why Are We So Clueless about the Stock Market? is a short, 150 page read that focuses on the principles espoused by some of the world's most successful investors. MagicDiligence recommends the book for both new investors and for experienced investors who are looking to "get back to the basics".

The book's first few chapters cover a fact that often gets lost in the din of technical trend following and macro-economic predictions: underneath a stock is a business, and the outcome of that business determines the outcome for an investment in its stock, over the long run. Skonieczny lays out briefly what a business is, and then talks about how a business creates wealth for its owners. For companies listed on public exchanges, those owners are stock investors. I liked how the book follows the passe example of a lemonade stand, starting out with "why start the stand"? The answer, of course, is to earn a better return on investment capital that can be achieved through alternatives like a savings account. The author then goes through factors that can erode these returns on capital, particularly competition, and how having an economic moat protects against this.

Later chapters cover the other points that investors need to consider, such as diversification, broader economic trends, IPO investing, and more. MagicDiligence found the most useful of these chapters to be the ones on valuation, complete with a number of discrete, real-company examples. Mariusz has a slightly different method for stock valuation then the traditional discounted free cash flow method. It is done similarly, though. An investor using his method should use a range of expected growth rates, estimate an ending P/E ratio, assign a required return (discount rate), and also estimate a dividend payout ratio over a 10-year period. Using these, one can determine two components of final return: capital value of the stock and dividends paid. Add these two together and you get a target stock price. Using the range of targets, you compare against the current stock price to see if there is a significant margin of safety. If there is, you buy.

These examples are very well documented too - the graphics in the book can easily be turned into a spreadsheet. Skonieczny even provides a bit of help by providing a "normal" range of discount rates, as well as using historical data to assign the other values. I liked this approach. While the discounted free cash flow (DFCF) method is the theoretically correct way to value a stock, this way focuses on estimation of the real-life potential returns. DFCF does not really adjust for stock market realities like average P/E ratios differing per industry, or the relative payout of dividends differing between companies.

Another chapter I found particularly interesting described in a brief but complete way how such large, respected firms like Fannie Mae (FNM), Freddie Mac (FRE), AIG (AIG), and Long-term Capital Management can implode in a matter of weeks. While the Magic Formula specifically screens out financial firms like these, it is absorbing to read about how debt can quickly destroy these companies. The explanation of financial leverage, why companies use it, and the dangers of using it was exceptional.

Mariusz Skonieczny obviously shares many of the same influences as MagicDiligence. Why Are We So Clueless... matches up exactly with Magic Formula Investing (MFI) by using return on invested capital to determine what is a good business and what is not. But the durability of that quality requires an analysis of competitive advantages, which both this book and MagicDiligence believe is best explained in Pat Dorsey's two books (The Little Book That Builds Wealth and The Five Rules for Successful Stock Investing ) via factors like regulatory barriers, unique assets, and economies of scale. MFI's short-cut for valuation, trailing earnings yield, can also be improved with a future-oriented examination like in the book. If the trailing earnings yield is not sustainable, or if the earnings yield is not out of the realm of historical valuation, the stock may not be that cheap. These kind of analyses protect Magic Formula investors from buying into "value traps".

Lastly, the brevity of the book may be its single greatest asset. Commonly cited investing primers, like Ben Graham's Security Analysis, are, frankly, very long and mostly boring reads, whose salient points have been extracted and compiled effectively in numerous shorter books, including this one. By maintaining focus and not getting too technical, Skonieczny presents only the important parts of successful fundamental investing. For beginning investors, this is a very good primer. Experienced value investors may not find a lot of new material here, but it is still a good refresher for staying the course.

1 Comments – Post Your Own

#1) On February 02, 2010 at 10:00 AM, russiangambit (29.27) wrote:

> The book's first few chapters cover a fact that often gets lost in the din of technical trend following and macro-economic predictions: underneath a stock is a business

I hear that often but I think it is a mistake to look at a stock this way. Let's say you are in a recession and you want to sell the businesses. You'll probably sell that business at 10-20% discount. Yet the stock in a recession could be down 40-50% easily.

Take a REIT, for example. If the properties loose 20-30% of their value ina recession, the REIT will go bust.

If you want to equate a stock to business, look at it as a business bought on 5:1 leverage. Business loses 10% of revenues, you lose 50% of stock value or more.

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