Transcript S03E05 — Getting Started (Part 3)

S03E05 — Get­ting Start­ed (Part 3)

Dura­tion: 49:14

Cameron: [00:08] Wel­come back to QAV. This is episode 305, or as I like to think it part 3 of our intro­duc­tion to QAV reboot that we’re doing ear­ly in 2020, record­ing this on the 6th of April, 2020. And this is actu­al­ly kind of part 2 of what we start­ed in three Oh three last week, which is the intro­duc­tion to the QAV check­list. So if you haven’t heard three Oh three yet, I sug­gest you go back and lis­ten to that. That’s sea­son three, episode three is the first part of our intro­duc­tion to the check­list. If you have heard that, well, this is part two, it is about anoth­er hour of walk­ing through the check­list step by step. And this week we pick it up with col­umn T is it the low­est PE in the last three years? Now, I think on the front page again of Stock Doc­tor and sec­tion five, share price Val­ley, you can scroll back­wards and see the PE. So we want to go back six halves to get three years. Is that right?

Tony: [ 01:18] Cor­rect. Yes.

Cameron: [01:19] We give it a score here, accord­ing to my guide here, two for the low­est, zero if it’s not the low­est and neg­a­tive one, if it’s the high­est.

Tony: [01:31] That’s right. Yes.

Cameron: [01:32] Do you want to talk us through why?

Tony: [01:35] Yeah. Again, it’s an indi­ca­tor of val­ue. So, I using three years was a bit arbi­trary but the think­ing behind it was, if you go back too far, the com­pa­ny could have evolved over time and the PE could have changed, but in the last three years and all things being equal, it’s prob­a­bly rough­ly the same sort of com­pa­ny it was three years ago and so we can com­pare its PEs. And if the PE’s the low­est in that three-year peri­od, that’s a sign of val­ue and if it’s the high­est in that three-year peri­od is prob­a­bly the sign of it being over­val­ued. So, we give it a check for a one or a zero or a minus one or two, I think, or a zero or minus one in the check­list accord­ing­ly.

Cameron: [02:16] Two zero and minus one yeah.

Tony: [02:18] Yeah. Thanks. Yeah.

Cameron: [02:19] So if it has the low­est PE in the last three years, it’s an indi­ca­tor that the stock is cur­rent­ly under­val­ued by the mar­ket.

Tony: [02:30] Cor­rect.

Cameron: [02:30] Alright. So, col­umn U is net equi­ty. This is straight up finan­cial data you can get it stock­doc, there go to the finan­cial state­ments, tab, state­ment of finan­cial posi­tion and look for the equi­ty row. Explain to us new­bies what net equi­ty means, Tony?

Tony: [02:48] Yeah. So just before I do that, so just in stock­doc, there we’re going to finan­cial state­ments and then there’s a tab and we’re click­ing of the one called state­ment of finan­cial posi­tion brack­ets bal­ance and that gives us the equi­ty. Yeah. So, to explain what equi­ty is, it’s tech­ni­cal­ly it’s the assets minus lia­bil­i­ties. So, for a com­pa­ny to have equi­ty, to have pos­i­tive equi­ty, it means it’s got to have more assets than it does lia­bil­i­ties. Assets are things like plant and equip­ment or the loans or prop­er­ty to the loans that it can be some intan­gi­bles that we’ve talked about before like Good­will. So, if it’s bought com­pa­nies Good­will is the dif­fer­ence between the equi­ty that’s buy­ing and the price it’s paid. And so that can go into the bal­ance sheet too. And there’s also oth­er times there’s an intan­gi­ble. So, things like the val­ue of say a brand, if it’s a very strong brand, like some…

Cameron: [03:46] [Cross-Talk­ing 00:03:47]. Well, some pos­i­tive word of mouth, about our wives on the strip of poles.

Tony: [03:53] Yes, that’s right. So, there can be rea­sons why there’s intan­gi­bles, but basi­cal­ly, we’re look­ing at the total assets and we’re tak­ing away the total lia­bil­i­ties. Lia­bil­i­ties, and the main, again, it’s going to be debt, but they’re also short-term things like sup­plies I have to pay, but haven’t paid yet, or also Cana­da is a lia­bil­i­ty.

Cameron: [04:14] And we’re going to be using this in a minute to deter­mine the val­ue of the assets that we’re buy­ing for every dol­lar spent. So, in my mind, if I think about the cof­fee shop, anal­o­gy think­ing what if the busi­ness costs us a hun­dred thou­sand dol­lars and to buy the whole thing and the net assets of the busi­ness a worth $110,000, it’s a low-risk invest­ment because I could sell the busi­ness for parts tomor­row. Okay, good. And Gekko it, split it up, sell it for parts. And I’d make a prof­it, but if the net assets are only $20,000 and I have to pay a hun­dred thou­sand dol­lars for it, it’s a high­er risk invest­ment.

Tony: [04:53] That’s right. You’re rely­ing more on the earn­ings to repay your, rather than the assets.

Cameron: [04:58] Yeah.

Tony: [04:58] In that case. Yeah. Yeah. That’s a good exam­ple. So, if the cof­fee shop and rent­ed its space, it’s going to have a lot less assets than the cof­fee shop, which owns its space. So, they own the build­ing that they oper­ate from and that might actu­al­ly have an effect on the val­u­a­tion that we pay for the com­pa­ny.

Cameron: [05:15] Okay. So, col­umn U is we ask the ques­tion, does the com­pa­ny have con­sis­tent­ly increas­ing equi­ty? And I think we get that from the same page that you said before, and again, it’s scrolls, so we can go right back. And how far do we want to scroll back here? And six halves again?

Tony: [05:35] Six halves again, that’s right. Again, no real sci­ence behind that. Oth­er than it gives us a train with­out going back too far. Which may be dis­tort­ed because the com­pa­ny has changed.

Cameron: [05:45] And so we’re going to give it a one for a pos­i­tive and a zero for a neg­a­tive here, because we’re try­ing to deter­mine how well man­age­ment is per­form­ing. If the net equi­ty con­tin­ues to increase steadi­ly, they’re doing a good job. They’re build­ing a busi­ness that’s grow­ing, you know, has more and more equi­ty half by half by half by half. If it’s going up and down, it’s an indi­ca­tor that it’s not steady growth and there might be some prob­lems.

Tony: [06:15] Yeah, that’s right. And if you remem­ber that, well, where as an own­er of the com­pa­ny, you’re a part own­er of the com­pa­ny, equi­ty is our asset. So that’s what we’re buy­ing. And if you think about it, what we’re try­ing to do is to have a com­pa­ny which gives us a good return on equi­ty and there­fore that equi­ty should be grow­ing. So, it can also be a sign of a com­pa­ny with a bumpy return on equi­ty num­ber or a low return on equi­ty num­ber as well.

Cameron: [06:40] Right. Well, col­umn W then is for, in my spread­sheet, I just copied the share price over again. It’s only there to be used as an easy ref­er­ence for the next col­umn, which is col­umn X. Which asks what the net equi­ty per share is, or NEPS, N E P S, NEPS also known as book val­ue. Is that right, Tony?

Tony: [07:08] Yeah. So that we’ve had some dis­cus­sion about whether it’s also called net tan­gi­ble assets per share, but I think we stick to book val­ue or NEPS is prob­a­bly a good way to go.

Cameron: [07:17] So this is anoth­er cal­cu­la­tion sell. Basi­cal­ly, I’m tak­ing the net equi­ty fig­ure that we just came up with and divid­ing it by the share price. And this is again, is telling me, you know, for every dol­lar that I spend, how much equi­ty I’m actu­al­ly get­ting.

Tony: [07:33] Yes, cor­rect. So ide­al­ly you want to pay a dol­lar for a dol­lar as equi­ty per share but no more than 30% above net equi­ty per share.

Cameron: [07:41] So this comes in the next col­umn. So, col­umn “Y” I asked the ques­tion is the share price less than the NEPs. It’s a score cell. So, it gets one for a yes. Blank for a no. Why blank for a no Tony?

Tony: [07:56] Well, again, it’s one of these boosts things because plen­ty of com­pa­nies won’t be trad­ing at their net equi­ty per share val­ue. It’s a fair­ly rare occur­rence, but if they are, it’s a thing we want to give an extra score on the check­list for.

Cameron: [08:10] But we don’t want to penal­ize them if they’re not.

Tony: [08:12] So, that’s right. Oth­er­wise, you’re penal­iz­ing most of the mar­ket.

Cameron: [08:15] Yeah. And then col­umn Z is the price to book ratio. Anoth­er for­mu­la, this one is the share price minus NEPs divid­ed by NEPs. This is giv­ing us a ratio for the next col­umn, col­umn AA which is the ques­tion that you were indi­cat­ing a few sec­onds ago. Is the share price less than 30% above NEPs, the net equi­ty per share? This is anoth­er score cell. Now this is what you’re say­ing, ide­al­ly, we don’t want to pay any more than 30% above the share price. This is more safe­ty mar­gin stuff. Why the 30% fig­ure is that, is there any sci­ence behind that or is it more black mag­ic?

Tony: [09:05] It’s not black mag­ic. It’s anoth­er steal from War­ren Buf­fett who has always said that he would be inter­est­ed in buy­ing back Berk­shire Hath­away shares if he thought that they were trad­ing at less than 30% of book val­ue.

Cameron: [09:19] And did he say why 30%? Is it just about risk mar­gin?

Tony: [09:25] I think he actu­al­ly did. I’m just stretch­ing my mem­o­ry here, but I think it was part­ly risk mar­gin, but part­ly also that can be again, because of all the intan­gi­bles, et cetera, it can be a dif­fi­cult thing to nail down book val­ue if you draw right down into it. So just giv­ing him­self a bit of a buffer there.

Cameron: [09:44] A buffer to Buf­fett. Oh, we’re on fire today, Tony.

Tony: [09:52] We’re in sync, aren’t we?

Cameron: [09:56] Buffer, part of being… Oh, Jesus, it’s gold. Okay. So, safe­ty mar­gin here. So, if we were spend­ing a dol­lar no if we’re going to buy a dol­lars’ worth of equi­ty, we don’t want to spend much more than a $1.33. Again, it’s just about min­i­miz­ing the risk. How much are you pay­ing for this thing? You don’t want to over­pay. When I was with you in Syd­ney a week or so ago, you were talk­ing about buy­ing a car and how you like to nego­ti­ate price before you buy any­thing. And you said, shares are exact­ly the same. And you know, we’ve said this a lot of times, but it’s worth repeat­ing. There’s two parts to QAV there’s qual­i­ty and there’s val­ue. That’s what the QAV stands for. If peo­ple haven’t worked it out yet qual­i­ty and val­ue, and you want to buy good qual­i­ty stock, but you don’t want to pay too much for it because I’m going, okay. So, the car anal­o­gy is going buy­ing a Mer­cedes-Benz. You don’t want that’s worth; I don’t know. Let’s say a hun­dred grand. You don’t want to pay 500 grand for it. Why would you do that? Why would you pay five times what some­thing’s worth? That’s ridicu­lous. When it comes to shares though, peo­ple quite often don’t have the mind­set of deter­min­ing the intrin­sic val­ue of the share. So, they will quite often over pay for some­thing.

Tony: [11:16] Yeah. And look, I think there’s a school of thought in invest­ing that pay­ing any­thing for qual­i­ty is to do a good invest­ment because you know, the com­pa­ny will keep going up and its share price will fol­low and over time you get your mon­ey back. I don’t sub­scribe to that and I don’t think any­thing’s worth over pay­ing for even if it’s the best com­pa­ny on the share mar­ket.

Cameron: [11:35] Well, it’s one of my favorite quotes is from Howard Marks at Oak­tree. He says, fig­ure out what some­thing is worth and then try to buy it for less.

Tony: [11:44] Exact­ly.

Cameron: [11:46] And I think he also says buy shares like you buy every­thing else when it’s on sale.

Tony: [11:51] Yes. Yep.

Cameron: [11:52] Which is of the dis­ci­pline of invest­ing val­ue invest­ing, right. Is only buy it when you can get a good deal.

Tony: [12:01] Yup. Every­thing’s a val­ue invest­ing if you look at it that way but a lot of peo­ple don’t on the share mar­ket for some rea­son. For all sorts of human psy­chol­o­gy, we’ve talked about before, like their mates have made mon­ey out of invest­ing in a tech stock, so they don’t want to be left behind. So, they go and buy it too. All sort of mis­takes I made with­in the first year of invest­ing.

Cameron: [12:20] The fear of miss­ing out, greed, emo­tion is what dri­ves the mar­ket. So, we’re try­ing to be more sci­en­tif­ic than that.

Tony: [12:28] Cor­rect. We’re try­ing to take the emo­tion out.

Cameron: [12:30] So col­umn AB, what is the earn­ings per share? Now this is straight up finan­cial data. We get it on stock­doc in the finan­cial state­ments page, under prof­itabil­i­ty, finan­cial state­ments, finan­cial met­rics, prof­it. You first have finan­cial met­rics prof­itabil­i­ty. It’s got an EPS and it’s expressed as sense. Yes. Do you want to explain that I’ve got a note here that it tells us some­thing about how well they’re invest­ing their equi­ty?

Tony: [13:05] So, earn­ings. Earn­ings per share is I think we spoke about it before. It’s the earn­ings part of the PE ratio. So, it’s how much prof­it is the com­pa­ny mak­ing divid­ed by its share price or prof­it per share, divid­ed by its share price and that gives us earn­ings per share.

Cameron: [13:19] Okay. And as I said, we’re grab­bing that num­ber here because in the next col­umn AC, we’re going to fig­ure it out, we’ll look to see what ana­lysts are say­ing the future earn­ings per share is and we can get this from two places. Stock Doc­tor has a future earn­ings per share some­times for some busi­ness­es, depend­ing on the size of the busi­ness. Some­times it does­n’t Share Analy­sis. Also share analysis.com also has a future EPS pre­dic­tion in there. And the way that I’ve learned to under­stand this is because you don’t try and become an expert on macro­eco­nom­ics or on the eco­nom­ics of a par­tic­u­lar indus­try or sec­tor or busi­ness, you don’t spend a lot of time drilling deep down into who their com­peti­tors are and what their R and D is like and where they’re lead­ing the mar­ket and all that kind of stuff, which some peo­ple do par­tic­u­lar­ly full-time ana­lysts do that kind of stuff. What you do is go and look at well, those pro­fes­sion­al ana­lysts who do under­stand the sec­tor and do under­stand what the com­pa­ny is doing and where they’re putting their mon­ey, what did they think the future earn­ings per share is going to be? And I’ll just take that. I’ll take the sum­ma­ry of a con­sen­sus from a num­ber of ana­lysts. And I’ll use that as my short­hand cal­cu­la­tion.

Tony: [14:43] Cor­rect. And just one more thing I’d say is that often­times the ana­lysts are doing a short­hand cal­cu­la­tion because they’re using the guid­ance from the com­pa­ny as well. So, most com­pa­nies, most large com­pa­nies will say, we think our earn­ings per share next year is going to be X, Y, or Z or with­in the range.

Cameron: [14:58] Wow. What do these ana­lysts get paid to do then? Just like read what the com­pa­ny says and repub­lish­es it.

Tony: [15:05] Thank you. Thank­ing of new ways of secur­ing how to invest so you can charge more fees. I don’t know.

Cameron: [15:10] Strip­per poles. Won­der if they’ve con­sid­ered that?

Tony: [15:15] They’ve already reg­is­tered badabing.com.

Cameron: [15:19] Yeah.

Tony: [15:19] Some­one has.

Cameron: [15:21] Way ahead of us. Okay, so that’s col­umn AC again. So, in Stock Doc­tor to find the future EPS, I should make a note of that. Is that in the same place where we got up before under prof­itabil­i­ty, they just have the esti­mate for the next peri­od.

Tony: [15:41] Cor­rect? Yeah. And I usu­al­ly just take the next peri­od. So, like Stock Doc­tor some­times we’ll have two peri­ods going for­ward, so this year and next year but I just should­n’t like just take the next peri­od and the same where Share Analy­sis it’ll have prob­a­bly two years of fore­cast, but I just take the next step fore­cast peri­od.

Cameron: [15:58] Okay. So then in col­umn AD I want to work out anoth­er for­mu­la. This is the growth of the earn­ings per share. So, the future earn­ings per share, sub­tract the cur­rent earn­ings per share, and then divide that result by the PE. Now you’ve told me before that this lit­tle for­mu­la is some­thing that you bor­rowed from Peter Lynch; he revers­es it. He calls it the PE over growth or the PEG ratio. And ide­al­ly, we want the growth of the earn­ings per annum to be close to the PE. Why is that?

Tony: [16:35] Well, Peter Lynch always thought that was the true intrin­sic val­ue for a com­pa­ny. So, tak­ing into account its growth and what you’re pay­ing for it now, he thought when they were equal, that was the right price to pay. I’d have to go back and reread his book to under­stand why that was the case. But basi­cal­ly, what he’s say­ing is that you can pay, I guess, in a broad sense, he’s say­ing you can pay more for a com­pa­ny that’s grow­ing quick­ly and you should pay less for a com­pa­ny that’s grow­ing slow­ly. So that for the PE to be equal, sor­ry for the PE over growth to be equal to one. Then if the growth is only 10%, the PE should be 10. And if the growth is 20%, then the PE should be 20. So, it’s basi­cal­ly say­ing you can pay more for a grow­ing com­pa­ny.

Cameron: [17:18] Okay. So, in the next col­umn, AE. We asked the ques­tion is the growth over PE high­er than 1.5? If it’s a, yes, it gets a one. If it’s no, it gets a zero and if it’s a neg­a­tive result, it gets a minus one. Why the 1.5 num­ber?

Tony: [17:39] Yeah. So again, I’ve prob­a­bly invert­ed Peter Lynch’s num­ber here, but if you do it the oth­er way around, he’s look­ing to buy things that are less than one. So, I think from mem­o­ry, he was say­ing 0.7, five. So basi­cal­ly, if you’re PE is 10, but the com­pa­ny’s grow­ing at 20%, that’s a Bali. So, you’re not pay­ing very much for that growth. I came across it more recent­ly in a dif­fer­ent pre­sen­ta­tion from a stock­bro­ker and they invert­ed it and used 1.5. So that’s what I’ve adopt­ed in my check­list.

Cameron: [18:12] So in essence, we’re using this to deter­mine if the com­pa­ny’s earn­ings are grow­ing faster than the price to earn­ings ratio?

Tony: [18:24] Yeah. Well, the PE does­n’t grow as so much, but we’re try­ing to find, like I said before, a com­pa­ny that’s grow­ing at 20%, but it’s P is only 10%, so it’s fast grow­ing, but we’re not pay­ing as much for it as that growth would indi­cate we should pay for it.

Cameron: [18:39] Right. But yeah, what I meant to say is that it’s grow­ing faster than what the cur­rent PE is, so the cur­rent PE isn’t tak­ing into account the future growth.

Tony: [18:50] Yes, that’s right, cor­rect.

Cameron: [18:51] Effec­tive­ly.

Tony: [18:53] Yes. Cor­rect. Again, anoth­er nature of val­ue.

Cameron: [18:56 ] Yeah. So, it’s say­ing we think this busi­ness’s earn­ings are going to grow, so the PE will grow the PE a year from now will be dif­fer­ent to what it is today but if we can buy it today at that price, and it’s not fac­tor­ing in what the earn­ings are going to be a year from now, we’re get­ting it at a good price.

Tony: [19:19] Cor­rect. Yeah. It’s cheap­er.

Cameron: [19:20] That sound­ed con­vo­lut­ed but I under­stood what I meant.

Tony: [19:24] I as just going to say, I think one thing that might be becom­ing clear to peo­ple who are lis­ten­ing to us is that we don’t just have one way of valu­ing a com­pa­ny. And, spoke about this before, I have found that there is no one KPI or no one met­ric that is a great indi­ca­tor of qual­i­ty or val­ue. What we’re try­ing to do is built almost like a radar map of all dif­fer­ent things that are ping­ing. And then if they ping on a num­ber of dif­fer­ent fronts, whether it’s book val­ue or book val­ue plus 30% or growth over PE all those kinds of things, then the score goes up. So, we’re not real­ly focus­ing on one way over any oth­er way.

Cameron: [20:05] You’re like a doc­tor, that’s lis­ten­ing to their chest, tak­ing their tem­per­a­ture you know, lis­ten tak­ing their heart rate, doing some blood analy­sis, blood work, stick­ing your fin­ger up their coy to check the prostate. You know, you’re, you’re fondling, you’re squeez­ing, check­ing. You’re doing a full check­up.

Tony: [20:28] That’s right? Yes. Just like a doc­tor.

Cameron: [20:31] I’m near­ing 50, I’ll be 50 the end of the year. So, you know, get­ting the old prostate exam is front of mind. I’m sor­ry to dis­turb peo­ple who had to visu­al­ize that, not look­ing for­ward to it. Or maybe, or am I? I don’t know.

Tony: [20:49] I can take you out the back of the bedaub­ing and give on a filler.

Cameron: [20:54] Do you charge extra for that? Okay, so col­umn F. So, we’re get­ting to the end here, let’s push through if that’s okay with you, if you’re up for it.

Tony: [21:07] Yep, sure.

Cameron: [21:08] I mean, push­ing through not the, rec­tal exam.

Tony: [21:12] Not the proc­tol­ogy.

Cameron: [21:15] Col­umn IF intrin­sic val­ue num­ber one. Okay. So, this is where we get down to brass tax. And we’re try­ing to, this is we men­tioned the dis­count­ed cash­flow in a recent episode which is some­thing that Buf­fett, peo­ple like him use to deter­mine what they think the val­ue of a com­pa­ny is. And we’ve talked about the fact that you have this cal­cu­la­tion called an intrin­sic val­ue. We do two of them, it’s sort of an esti­ma­tion or a short­cut of heuris­tic to achieve sort of the same thing as doing a full DCF cal­cu­la­tion. Our IV num­ber one is the cur­rent earn­ings per share the cur­rent EPS divid­ed by 19.5%, which is one of the hur­dle rates that we look at. This took me a long time to get my head around. Can you explain what a hur­dle rate is Tony?

Tony: [22:09] Yeah, sure. So, when we’re talk­ing about dis­count­ed cash flows, the hur­dle rate is the dis­count­ing fac­tor. So, it’s basi­cal­ly say­ing that if I’m going to buy the cof­fee shop and I’m going to project out into the future, what it’s cur­rent­ly earn­ing I’m going to dis­count that future cash­flow for two rea­sons. One because there’s risk and two, because the mon­ey of the day in the future is not worth what the mon­ey is now. So, I think we spoke before about if I agreed to give you a thou­sand dol­lars in 10 years’ time, how much would you pay for that con­tract now? And you can take into account the risk of me not being around in 10 years’ time or hav­ing a thou­sand dol­lars to pay you. And also, the fact that a thou­sand dol­lars in 10 years’ time might be worth $700 now, or 600 or 500 or what­ev­er. And so again, try­ing to put some sci­ence around it, the hur­dle rate is the you use to dis­count the future cash flows. I use 19.5% in this first IVF cal­cu­la­tion because that’s what my long-term return has been in the mar­ket. So, I’m look­ing for stocks that I want to add, which are get­ting bet­ter than that hur­dle rate. It’s a very small sam­ple set, but if they do achieve that sort of met­ric, they’re real­ly worth­while look­ing at.

Cameron: [23:30] And so one of the things that I want to point out to peo­ple too, is that quite often the cur­rent share price will be above pour IV fig­ure. And we may still end up giv­ing it a by writ­ing because as you’ve explained to me in the past, this is just, again, one mea­sure­ment. It’s not nec­es­sar­i­ly a go, no go like the sen­ti­ment is it’s not the be all and end all. It’s just one more data point that we’re look­ing at. Ide­al­ly, we would like to be able to buy the share for what our intrin­sic val­ue is or less but if it’s above that today, that’s not nec­es­sar­i­ly a deal break­er.

Tony: [24:14] No, and that’s right. It’s part­ly because the par­tic­u­lar­ly IV num­ber one is a very, very high bar just count­ing the earn­ings per share into the future by a high hur­dle rate means it’s got to be in deep val­ue before you buy it. And that’s great if it hap­pens, but it may, we don’t want to nec­es­sar­i­ly roll com­pa­nies out that don’t quite meet that hur­dle rate.

Cameron: [24:41] Right. So, in my spread­sheet, peo­ple will see that the next col­umn AG is just the cur­rent share price copied over from ear­li­er again, just for easy ref­er­ence, because col­umn AH asked the ques­tion is today’s price below IV num­ber one? If it’s a, yes, it gets a one. If it’s a, no, it gets a zero. So again, not the end of the world, if it is below the IV, but it just, it gets a score if it does just all adds up at the end of the day.

Tony: [25:15] Yeah.

Cameron: [25:15] The next col­umn AI is intrin­sic val­ue num­ber two. Again, it’s a for­mu­la, but in this case, we take the future EPS that we grabbed ear­li­er from Stock Doc­tor, or you can get it from Share Analy­sis and we divid­ed by a dif­fer­ent hur­dle rate, the mar­ket hur­dle rate. And this is one that I think tricks a lot of peo­ple up Tony. So, and in fact, as some­body point­ed out to me ear­li­er that in the first time when we first did our get­ting start­ed episodes, I screwed this up the way I explained it. And it took until now for some­body to point that out to me. So, I don’t know what every­one else has been doing when they lis­tened to it, just when right over their heads, maybe. But why don’t you explain the sec­ond hur­dle rate, the future IV2 hur­dle rate?

Tony: [26:00] Yeah. So, IV two hur­dle rate users what’s often called the mar­ket hur­dle rate. So again, it’s a norm in account­ing to user a risk pre­mi­um for stocks of 6% and then to add in the long-term inter­est rate, which is cur­rent­ly 0.25%.

Cameron: [26:18] Sor­ry. Can I just, is Norm in account­ing like Scot­ty from mar­ket­ing? Is that, should we like Norm in Cheers? No, what’s up Norm? My nip­ples it’s cold out­side. What should… Sor­ry, please keep going.

Tony: [26:34] Oh, that’s okay. No, I think there’s some sci­ence behind it, way back when maybe a hun­dred years ago that some­one said, look, if I’m going to buy stocks rather than bonds, I want to pay less for the stocks and the bonds. And that risk pre­mi­um is being cal­cu­lat­ed as 6% for a long time. So, most fund man­agers in the mar­ket will be using 6% plus the long-term inter­est rate. So, 6.25% is the cur­rent hur­dle rate, which is com­mon­ly used.

Cameron: [27:03] So let’s explain the long-term inter­est rate. This is the RBA cash rate?

Tony: [27:08] It is. Yes, that’s right. And it’s gen­er­al­ly the right that applies to a 10-year gov­ern­ment bond.

Cameron: [27:16] Right. So, okay. That’s why that’s impor­tant. So that’s what I could get for a bond, noth­ing effec­tive­ly right soon to prob­a­bly go to zero. Yeah. And I want to get at least 6% bet­ter than that. If I’m going to take the risk of invest­ing in stocks.

Tony: [27:36] Cor­rect. That’s right. Com­pared to putting your mon­ey into bonds. Yep

Cameron: [27:39] Col­umn AJ asked the ques­tion is the share price below IV num­ber two again, so before it’s a, yes. It gets a one. If it’s a, no, it gets a zero. In some cas­es IV, two will be blank because the EPS. Sor­ry, the future EPS will be blank. We can’t get one. I find this is quite often with small­er com­pa­nies that don’t have ana­lysts look­ing at it.

Tony: [28:07] Cor­rect. Yes. And that can be a good thing for us because if we found a com­pa­ny which the ana­lysts haven’t found yet, because it’s too small as it grows, if it scores well on our check­lists, we’re hop­ing for it to grow. Then as it gets end­less, start­ing to report it, report on it, then we get more investors buy­ing it and that dri­ves the share price up.

Cameron: [28:28] Yeah. So, it’s not nec­es­sar­i­ly a bad thing.

Tony: [28:31] Cor­rect. Yes.

Cameron: [28:32] Col­umn AK asks the ques­tion is IV num­ber two, more than twice the cur­rent share price. If it’s a, yes. It gets a one. If it’s not gets a zero, if the FEPS is a blank, so is this. Why do we have this ques­tion in there, Tony?

Tony: [28:48] Yeah. Again, it’s an exam­ple of a com­pa­ny sell­ing with a price, which is at extreme val­ue. So, if we think the val­ue of the com­pa­ny is a dol­lar per share by error IV is say­ing that it’s 50 cents, then it’s again, an indi­ca­tor of it prob­a­bly being very under­val­ued.

Cameron: [29:09] Col­umn AL asks whether or not it is a start stock on Stock Doc­tor gets a one for a yes. Zero for a no. And a Star Stock is basi­cal­ly a health rat­ing from Stock Doc­tor. Right?

Tony: [29:25] Cor­rect.

Cameron: [29:25] And you can tell if it’s a Star Stock, because when you go to the first page for that com­pa­ny on the Stock Doc­tor, if it is it’ll have stars beside its name.

Tony: [29:36] Yeah. And they use three stars from mem­o­ry. So, we need to be care­ful here. So, if it’s a Star Stock, it gets a one, but they also have a Green­star, which is called a bor­der­line star growth stock. So that’s a stock, which is almost a Star Stock. And they have a pur­ple star, which is what they call a star income stock. So, it’s a stock which pays a good yield and it’s also has a good qual­i­ty score. So, I give star growth stocks a score of one and 0.5, if they’re bor­der­line or star income stocks.

Cameron: [30:08] What col­or is the star growth? Can you remem­ber?

Tony: [30:11] It’s gold.

Cameron: [30:13] Right. So, bor­der­line gets a 0.5.

Tony: [30:18] Yeah. So, I’ve got BHP open in front of me at the moment. It’s a bor­der­line plus a star income stock. So, we would score it 0.5 plus 0.5 or one.

Cameron: [30:27] Oh, it gets a 0.5 for star income too.

Tony: [30:30] Yeah.

Cameron: [30:32] Okay. And this is basi­cal­ly just again, giv­ing is we’re tak­ing advan­tage of the fact that there are ana­lysts at Stock Doc­tor that have delved down deeply into the finan­cials and the prog­nos­ti­ca­tions. They’ve gone beyond the proc­tol­ogy exam. They’ve done put it in an MRI machine. They’ve done ultra sounds and they’re giv­ing it a rat­ing away going. Yep. Thanks very much. We’ll use that. Whack it into our cal­cu­la­tions.

Tony: [31:09] Yeah. So, I spoke before about Merv Lin­col­n’s work­ing to com­pa­nies that go bank­rupt and how he came up with a list of ratios to mea­sure the finan­cial health of com­pa­nies. So, there’s the Star Stock process goes one step fur­ther, and it’s all laid out on the front page of the, of Stock Doc­tor. So obvi­ous­ly the com­pa­ny has got to have strong finan­cial health. They, I think from mem­o­ry, they look at things like whether earn­ings per share growth is going up by 8% or more from mem­o­ry. So, they’re look­ing at growth. They’re look­ing at the out­look that may be where they score, whether it’s going up or not. They look at the div­i­dend yield for a star income stock cri­te­ri­on. From mem­o­ry, they’re look­ing at return on assets above 8%. And I think return on equi­ty. Yeah. I’m not sure what the score is. Maybe 12%. Any­way, all these num­bers are out­lined in Stock Doc­tor and you can look it up if you like. They have their own ver­sion of the sen­ti­ment check, which is, there is the max that they look at. Yeah. And so, it’s not just the finan­cial health of the com­pa­ny, it’s a few oth­er met­rics that they put into their check­list and give stocks a Star Stock, or a bor­der­line stock rat­ing.

Cameron: [32:24] Right. And then we go over to our old friends, Share Analy­sis, shareanalysis.com. And we look to see what they’ve giv­ing it for their own health rat­ing and where they use a sys­tem ABCs, I think Ds and also, num­bers.

Tony: [32:48] Cor­rect. Yeah. So, the let­ter, I think from mem­o­ry is the strength of the bal­ance sheet and the num­bers that the strength of the prof­it and loss state­ment. And so, you’re look­ing for A ones, A twos, B ones and B twos has been the high­est qual­i­ty and the Share Analy­sis uni­verse.

Cameron: [33:06] So if it gets an A one, A two or B one or B two on Share Analy­sis, it gets a one. If it does­n’t, it gets a zero. You can find this on Share Analy­sis. You go to the sum­ma­ry page, look at the first two graphs, qual­i­ty and per­for­mance. These ones, the A, and one’s the num­ber, see where if it gets an A one, A two, B one or B two. Col­umn AN ask, what is the Stock Doc­tor cur­rent intrin­sic val­ue? This is anoth­er finan­cial data page. This is again, sec­tion five on the nine gold­en rules page. And I think we use either the Lin­coln val­u­a­tion or the con­sen­sus val­u­a­tion here.

Tony: [33:51] Yes. We give pref­er­ence to the Lin­coln val­u­a­tion if it’s avail­able but Stock Doc­tor only gives all income val­u­a­tion for its Star Stocks. Also, they bor­der­line ones in their Star Income Stocks. So, if it’s not part of that set, then they don’t give a val­u­a­tion. And we use the con­sen­sus val­u­a­tion, which is also avail­able on start-stock. I’m sor­ry to Stock Doc­tor.

Cameron: [34:12] Right. So, this appears as like a lit­tle heat map, like?

Tony: [34:18] Cor­rect. Lit­tle graph. Yep.

Cameron: [34:20] And the big num­ber in the mid­dle under fair val­ue. That’s the fig­ure that we’re look­ing for.

Tony: [34:25] Yes, that’s right.

Cameron: [34:27] So, we take that val­u­a­tion and I throw it into the spread­sheet. If you don’t have Stock Doc­tor, I think you can use, if you go over to Yahoo finance, you’ll find that they have a con­sen­sus esti­mate as well for some stocks.

Tony: [34:44] Cor­rect.

Cameron: [34:44] If Stock Doc­tor does­n’t have it and you don’t want to use the Yahoo finance one, we just leave this cell blank.

Tony: [34:53] Yes, that’s right. As we said before, for small­er com­pa­nies, we some­times don’t get an eval­u­a­tion on them.

Cameron: [35:00] So he does­n’t get penal­ized if we don’t have one, it’s just like, it does­n’t add to a total score.

Tony: [35:04] Cor­rect.

Cameron: [35:05] But then in col­umn AO, I asked the ques­tion is the cur­rent share price beneath the Stock Doc­tor intrin­sic val­ue, same sort of ideas, our own intrin­sic val­ues? Again, it gets a one for a yes. Zero for a no. But if the pre­vi­ous cell was blank in that we don’t have an IV, then we leave this one blank as well. Sim­i­lar process col­umn AP what is the Share Analy­sis cur­rent intrin­sic val­ue? This is anoth­er finan­cial data sale. You get it on the val­ue ver­sus price tab on Share Analy­sis. Again, if they don’t have an IV leave the cell blank. And the next col­umn, AQ asks is the cur­rent share price beneath the Share Analy­sis intrin­sic val­ue? One for a yes, zero for no. Blank if it’s blank, if they don’t have one. Col­umn, AR asks is the intrin­sic val­ue on Share Analy­sis, going up in the future? You can find that on Share Analy­sis on the same val­ue ver­sus price tab. Then we get to the col­umn AS which asks is the finan­cial health from Stock Doc­tor sta­ble or increas­ing? We get this on the finan­cial health box on the home page, the nine rules page, Tony?

Tony: [36:28] Yeah. So, on the nine rules page, you’ll see a series of bar charts. If that gets too hard to read it, should­n’t boot. Some­times it can, you can go into finan­cial state­ments and again, on the finan­cial met­rics page, you’ll see it in the first row of that page in quite bold col­or-cod­ed scores with a finan­cial health rat­ing of strong or oth­er­wise, and a lit­tle num­ber behind it in the brack­ets, which is actu­al­ly the score it gets when you run it through those mobile and can met­rics.

Cameron: [37:04] Right. So how do we tell if it’s sta­ble or increas­ing using just sec­tion one here, strong. It’s a BHP has got a big strong in the cir­cle,

Tony: [37:16] Cor­rect.

Cameron: [37:16] Is that sta­ble or increas­ing?

Tony: [37:18] Go below there, so it says L score June 15 to Decem­ber 19. And we’re look­ing at the last two columns here, which is the last two scores for the HP.

Cameron: [37:29] It says dis­tress.

Tony: [37:31] No, I’ve got strong

Cameron: [37:32] Above that. It says dis­tress.

Tony: [37:34] Yeah. Sor­ry. It does. Does­n’t it? I don’t know why it’s say­ing that, but it’s strong.

Cameron: [37:38] It’s strong. So again…

Tony: [37:40] Prob­a­bly goes for above the last col­umn it says Decem­ber 19 strong.

Cameron: [37:43] Strong. Yeah. It says dis­tress above it, but we’re look­ing at those bars…

Tony: [37:49] Sor­ry, I know why that is it’s because if we went to a com­pa­ny where it was the stress, the col­umn would go all the way up to touch the dis­tress.

Cameron: [37:56] Oh, I see. It’s strong.

Tony: [38:00] Yeah. For some rea­son, a health­i­er com­pa­ny is a low­er score.

Cameron: [38:04] Oh, I see. Right. Okay. So, how do we score this then? So, I’ve got for increas­ing. We give it a two for sta­ble. We give it a one. Any­thing else is zero. If it’s just strong, strong, strong, strong, strong, we say that sta­ble?

Tony: [38:24] Cor­rect. That’s a one.

Cameron: [38:27] Right and if it was just going from weak to strong, that’s increas­ing.

Tony: [38:31] Yes. And we’re just doing the last two reports. So, in this case, June 19 and Decem­ber 19.

Cameron: [38:39] Alright. So, col­umn AT asks is the CEO or a board mem­ber, a founder. This is anoth­er score cell gets two for a yes. Zero for a no. This I believe is because War­ren buf­fet has often said that he believes com­pa­nies where the founder is either a CEO or is still active on the board will often out­per­form oth­er com­pa­nies. Is that cor­rect?

Tony: [39:04] Cor­rect. That’s right. Yeah. Yep. No, yeah. There’s noth­ing like hav­ing skin in the game. So, we will, I mean, yes, it’s great if it’s a founder, but we’ve some­one else’s on the board or in the com­pa­ny that has a very large share­hold­ing we’ll also score that too as a founder.

Cameron: [39:18] Now on Stock Doc­tor, up in the lit­tle menu, there there’s a lit­tle pic­ture of a sil­hou­et­ted per­son wear­ing a tie. That’s the cor­po­rate details tab. If you click on that, you’ll see the cur­rent direc­tors and man­age­ment, and then we’re look­ing at the per­cent­age under ordi­nary secu­ri­ties, the per­cent­age of the com­pa­ny that they own. Yeah?

Tony: [39:40] Yeah. Cor­rect.

Cameron: [39:43] How big a per­cent­age does it need to be to deter­mine whether or not they’re a founder we’re look­ing at sort of 20% or more?

Tony: [39:50] No, I’d actu­al­ly go low­er. It’s a good ques­tion. I’ve gone as low as 5%. If I think that that the per­son was a founder and they’d been dilut­ed over time then I’ll go down to 5%, but prob­a­bly around 10%, it’s a good num­ber because maybe the com­pa­ny may well have grown a lot in the com­pa­ny and they own, and may well have had to have down to achieve that growth too.

Cameron: [40:15] Right.

Tony: [40:15] It’s often times are requests from insti­tu­tion­al investors for the founders to sell down, to improve liq­uid­i­ty in the stock.

Cameron: [40:22] Okay. So, again, they get a two for a yes. Zero for a no. So, col­umn AU then is the sum of the scores. So, we’re adding up all of the score cells. If it’s a blank and obvi­ous­ly we don’t add it up and their bid in col­umn AV we count the num­ber of check­list items that got a score, ignor­ing the blanks. That’s a null result because in col­umn AW we want to come up with a check­list score, which is where we’d take the total score divid­ed by the num­ber of check­list items and this gives us the qual­i­ty score of the stock. And ide­al­ly, we want this to be high­er than 75%. Why 75% Tony? Is this a mag­ic to that num­ber?

Tony: [41:14] No, that’s black mag­ic.

Cameron: [41:18] Black mag­ic.

Tony: [41:18] Yeah, look, inter­est­ing­ly enough that was some­thing I used to look at, but it’s prob­a­bly gone by the way­side now because if a com­pa­ny scores less than that, I’ll still buy it if it’s cheap which we’ll get to in a minute when we mul­ti­ply the qual­i­ty score by the price oper­at­ing cash­flow.

Cameron: [41:37] Yeah. So that’s the last col­umn. Col­umn AX, well kind of the last col­umn. This is where we give it a QAV score. This is where the rub­ber meets the road. We take the check­list score from col­umn AW divid­ed by the price to cash flow num­ber, which was col­umn L price to cash ratio and that will give us a num­ber. If that num­ber is greater than 0.1, it’s a buy. If it’s less than 0.1, it is not a buy.

Tony: [42:19] Cor­rect.

Cameron: [42:20] You want to explain why 0.1 is the mag­ic num­ber there, Tony?

Tony: [42:25] Yeah. Again, black mag­ic. No, so in the past when what we’ll do prob­a­bly next is to talk about rank­ing these com­pa­nies in order of their QAV scores. So, I won’t get to the QAV score, rank all the com­pa­nies I’ve scored and then start to buy the ones with the high­est score. And it just, I mean, it just seemed to be that I was, you know, I had too many com­pa­nies when I start­ed to get down into any­thing less than 0.01. Oh, sor­ry, point one. So that’s real­ly where it’s come from. The rea­son why I have done that is because, why I’ve used the score of 0.1 is because if it’s the report­ing sea­son and I haven’t ana­lyzed all the com­pa­nies yet, because they haven’t report­ed, but I come across some of the score more than 0.1, I’ll buy them straight away rather than wait­ing for the whole report­ing sea­son to fin­ish, and then rack­ing and stack­ing all the scores and buy­ing down the list. So0.1 is just an easy thing to remem­ber. And it’s also about where we start to have enough com­pa­nies in our port­fo­lio.

Cameron: [43:32] One of the things that we haven’t spo­ken about, I guess and we should point out to new lis­ten­ers is you, don’t like to have more than about 20 stocks in your port­fo­lio at any giv­en time.

Tony: [43:43] Yeah. Cor­rect or at least start off that way. Some­times it grows a bit big­ger than that. Some­times it’s at the moment. It’s much less than that. Yeah. So that’s, again, just a rule of thumb. What tends to hap­pen, the more stocks you have, you tend to get a smooth­ing of your returns. So, you’re not going to get, you know, sort of punch the lights out returns. If you have a lot of stocks, you’re going to prob­a­bly start to track the index clos­er than what you would, if you had a small num­ber. And that just makes sort of com­mon sense that if you have one stock in your port­fo­lio went up and it went up more than the mar­ket, then you’re going to beat the index and not cor­re­late to the index. Once you get to about 15 to 20, then you’re start­ing to have enough that makes it man­age­able, but also gives you some­thing which you can­so if some­thing does real­ly well, I can still have a mean­ing­ful impact on your total port­fo­lio returns.

Cameron: [44:39] Right. And you found that by mak­ing the cut­off 0.1, it just tends to nar­row down the list to the best 20 or so com­pa­nies.

Tony: [44:51] 20 or 30. Yeah, exact­ly.

Cameron: [44:54] Yeah. Alright and then real­ly all that’s left is, if it gets a buy, we often talk about the fact that you want to look at what the aver­age trad­ing vol­ume is because for you and peo­ple like you, that are deal­ing in large sums of mon­ey, you don’t want to get stuck buy­ing too much of a com­pa­ny that has a low trad­ing vol­ume, because it might be hard to get out if you want to get out at a lat­er point.

Tony: [45:23] Cor­rect. And it also might be hard to get in. So, unless you’re very, very patient and buy­ing small amounts of shares, you’re dri­ving the price up on the way in and dri­ving it down on the way out.

Cameron: [45:33] Right. And you want to speed, what is it about no more than 10% of the aver­age dai­ly trad­ing vol­ume?

Tony: [45:42] Yeah. I’ll go as high as 20.

Cameron: [45:43] Right.

Tony: [45:43] But that’s about it. Yeah. You don’t want to be too much above that,

Cameron: [45:47] But for those of us that aren’t yet deal­ing in mil­lions of dol­lars of buys and sells, prob­a­bly not an issue.

Tony: [45:55] No, but which is one thing we do though with the QAV port­fo­lio is we look at com­pa­nies and score them and put them in the port­fo­lio, regard­less of their aver­age dai­ly trans­ac­tion val­ue but some of them are pret­ty small. So even if you’re only trad­ing in tens of thou­sands of dol­lars, you still want to pay atten­tion to that aver­age trad­ing val­ue, aver­age dai­ly trad­ing val­ue, just to make sure you’re not going to flood the mar­ket either way, you know?

Cameron: [46:23] Alright. Well, that’s the check­list overview, Tony.

Tony: [46:25] Whew, man. That was a long pod­cast.

Cameron: [46:29] I’ll break that into two.

Tony: [46:31] Okay.

Tony: [46:33] Yeah. That was long but was good. So, we’ve gone through that in detail now. Again, if you’re a QAV club sub­scriber, go up to the check­list page, you’ll be able to down­load short­ly, if not already, by the time you lis­ten to this, the get­ting start­ed man­u­al where I’ve tak­en every­thing that we’ve just talked about and sort of con­densed it down to the main points into a writ­ten doc­u­ment that you can look at as you’re doing this. So, you don’t need to try and, you know, find the spot of the pod­cast where we talked about what a price to cash ratio is every time you can just look at a writ­ten descrip­tion, good luck with that. If you have any ques­tions, email me, [email protected]. And I can throw your ques­tions into next week’s episode when­ev­er that may be like. It does­n’t mat­ter when you’re lis­ten­ing to this, it’ll be in the next episode is what I’m say­ing. And again, as I’ve said before, hap­py if it doesn’t wor­ry about the fact that we may have answered ques­tions before you, we’re not wor­ried about repeat­ing our­selves, because if you don’t under­stand that there’s prob­a­bly hun­dreds of peo­ple that have just start­ed lis­ten­ing, who also don’t under­stand it and rather than me hav­ing to com­plete­ly repeat­ed­ly say, go back and lis­ten to this episode or that episode, we can just keep cov­er­ing. We can keep cov­er­ing it over and over again. And I think any­one lis­ten­ing, it does­n’t mat­ter how many times they’ve heard you talk about it as a sub­ject get bored with hear­ing you talk about it again. Right? So, it’s one of those things that we can just keep going over the basics, the fun­da­men­tals repeat­ed­ly, because it just sinks in every time, I hear you talk about it a lit­tle bit more.

Tony: [48:06] Yeah. Good point.

Cameron: [48:07] Alright. Well good. Thank you, Tony. We’ll be back next week. Good luck with your investing’s. Stay safe, Tony, stay iso­lat­ed. I don’t want you to catch the virus. I don’t care if I catch it, but I don’t want you to catch it. So, no golf. You’re banned from golf until we’re through this. Just get one of those like vir­tu­al golf things that I see in Hol­ly­wood movies, like get a room of the par­lor, put a sheet up on the wall. Put the pro­jec­tor, smack the ball into that and get by,

Tony: [48:37] Right. Yeah, that would be good. Well, I might play golf if they keep the golf cours­es open in new South Wales. That’d be good. It’s good to get out. Yeah,

Cameron: [48:47] No. Well, you’re only allowed to play by your­self though just…

Tony: [48:51] Cor­rect.

Cameron: [48:52] Or you and a priest. Okay. Cheers Tony.

Tony: [48:55] Thanks Cameron. Bye.