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The 85 investing lessons herein will teach you for the first time how to invest like the successful investor. Although these 85 investing lessons are not revolutionary, they endure the test of time. Indeed, there exist a few core lessons that underlie successful investing, and while these lessons do not change, the common investor does. It perplexes the common investor how easily the successful investor builds his wealth. However, for the successful investor, investing is like picking cherries in an orchard of corn. Furthermore, with each core chapter throughout, important investing lessons are taught. To effectively learn the 85 lessons from the successful investor, a lessons learned section follows each core chapter. So that long after reading Lessons From The Successful Investor, one can simply glean back to those lessons learned to refresh his knowledge. Without further introduction, enjoy and study diligently the 85 lessons from the successful investor, for he will prove to be your wisest and most profitable investing teacher.

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Chapter 1

MARKET HISTORY

"Those who cannot remember the past are condemned to repeat it."

George Santayana

1: Boom and Bust

S&P 500 (1950-2010)

The chart above shows the S&P 500’s performance from 1950 to 2010. A sixty year historical chart is shown to illustrate that over the long term, the S&P 500 has increased in value. Notice the S&P 500’s power tread line – a smooth upward progression. However, also notice the S&P 500’s two significant declines from 2000 to 2002 and from 2007 to 2009. The former period is coined the technology bust while the latter period the financial crisis. Both periods resulted in significant stock market destruction. Moreover, preceding the technology bust, investors adamant on infinite growth in the technology sector invested rapidly in severely overvalued technology stocks. And preceding the financial crisis, the U.S. housing bubble pop precipitated the implosion of Wall Street’s collateralized loans, seizing global credit markets. In the aftermath of both periods, the S&P 500 and global markets alike experienced a rapid fire sale, thrusting stock prices downward across the board. Furthermore, during market decline the successful investor simply gleans back to his historical charts to assure himself markets move upward in the long term.

Lesson Learned 1: Through boom and bust, the market moves upward.

2: This Time, It’s Different

Gloom quickly ensued as stock markets fell like falling knives in both the 2000 to 2002 and 2007 to 2009 periods. For instance, the financial crisis loomed so great in 2008 that experts touted a second great depression was mushrooming. And with each period, investors and experts alike exclaimed, “this time, it’s different”. However, market declines are both common and similar. Understanding this, the successful investor is unfazed by market turbulence. First, for every decade hereafter, the successful investor expects at least seven market declines. Second, after every substantial market decline, the successful investor expects the S&P 500 to emerge again. For example, in 2009 the S&P 500 reversed its 2008 decline of -37.22% to post gains of 27.11% and in 2003 the S&P 500 reversed its 2002 decline of -22.27% to post gains of 28.72%. Clearly, the process of decline and recovery was similar for both the technology bust and the financial crisis. Never succumb to the mentality that the market is “different this time”.

Lesson Learned 2: It’s not different this time.

3: Profit from Loss

The successful investor understands it is profitable to invest at the nadir of stock market decline. As Warren Buffet prescribes, “be fearful when others are greedy and greedy when others are fearful”. Fearful investors drive the stock market down to bargain levels during perceived catastrophe; the point in which the successful investor becomes greedy. One may wonder when one should invest during broad market decline, weary of catching a falling knife. The successful investor simply invests in stocks of quality businesses that are trading at attractive valuations and does not worry if those stocks should decline. “If you wait for the robins, spring will be over” is a sobering quote from Warren Buffet, who stresses that not even the successful investor can accurately time the market. Thus, he must invest at perceived point of nadir, otherwise, miss the market’s rebound. Conversely, the common investor sits on the sideline during broad market declines, waiting for an “opportune time to re-enter the market”, to then later regret missing significant market advances. Overall, the successful investor appreciates market declines as he can then invest in quality businesses at a discount.

Lesson Learned 3: Significant returns are got by investing at market nadir.

4: Investor Business Cycle

The successful investor has studied the investor business cycle diligently. Otherwise, he succumbs to buying stocks high and selling stocks low. The Investor Business Cycle: the common investor sells stocks at “panic”, completely sells out at “gloom”, buys in slowly again at “hope” and becomes fully invested again at “euphoria”. The successful investor never sells stocks at “panic” or “gloom”, but invests more at “gloom”, and rides the wave.

Lesson Learned 4: Invest during gloom, never sell, and ride the wave.

5: Wal-Mart is Dead

Investing in a stock that has for years been sputtering on the market is challenging. One may ask himself, “if I invest in this stock, what if it sputters for another ten years?” However, one should find comfort in that a sputtering stock will eventually be awoken by the growth beneath.

Wal-Mart (1989-2010)

Looking at its chart, there is no question Wal-Mart sputtered from 2000 to 2010. However, a sputtering stock is advantageous to the successful investor, if of course that stock is coupled with underlying business growth. For instance, while Wal-Mart’s market capitalization has hovered around $180 billion, its underlying business has grown. To explain, from 2000 to 2009, Wal-Mart’s revenue grew from $191 billion to $405 billion, net income grew from $6 billion to $14 billion, earnings per share grew from $1.40 to $3.66, book value grew from $31 billion to $70 billion, and because its stock remained flat, Wal-Mart’s P/E fell from 30 to 13, while its dividend yield grew from 0.40% to 2.1%. The successful investor would then conclude, based on its underlying growth, Wal-Mart’s stock was undervalued. Conversely, the common investor would conclude, based on its stock chart, Wal-Mart’s stock was dead.

Lesson Learned 5: A sleeping stock will eventually be awoken by the growth beneath.

6: The Market is Dead

In the August 13th, 1979 issue of Business Week, the cover story heralded “The Death of Equities”. The introduction started with:

“The masses long ago switched from stocks to investments having higher yields and more protection from inflation. Now the pension funds—the market's last hope--have won permission to quit stocks and bonds for real estate, futures, gold, and even diamonds. The death of equities looks like an almost permanent condition--reversible someday, but not soon.”

Let us take a look at the S&P 500’s total returns following Business Week’s article, “The Death of Equities”.

S&P 500 Total Returns (1979-1989)

Evidently, the S&P 500 grew at rapid pace from 1979 to 1989, just after “The Death of Equities” was published; a stark contrast to its performance in the prior decade, as shown below.

S&P 500 (1970-1979)

The S&P 500 from 1970 to 1979, preceding its ten year advance, sputtered, much like Wal-Mart did from 2000 to 2010. And parallel to Wal-Mart’s growth then, the S&P 500’s earnings increased 164% from $5.51 to $14.55 1970 to 1979. Clearly, the market was grossly undervaluing S&P 500’s earnings from 1970 to 1979, and only just after “The Death of Equities” was published did the market align with underlying growth. Thus, the market is never permanently dead.

Lesson Learned 6: A dead market will revive; do not miss its return.

7: The Lost Decade

S&P 500 (2000-2010)

As shown by its chart, the S&P 500 sputtered from 2000 to 2010. So for good reason, this period is referred to as the lost decade; a dismal period for the S&P 500 and other major markets. To illustrate, $1,000 invested in the S&P 500 in 2000 would be $640 in 2010, a 36% loss. However, while the S&P 500 sputtered during the lost decade, select individual stocks flourished. McDonald’s, for example, delivered its shareholders 106% return from 2000 to 2010, effectively turning a $1,000 investment into $2,060. McDonald’s is prime example then that broad market returns do not qualify individual stock returns. For this reason, ignore the pundit who every market decline touts buy and hold investing is dead. Furthermore, one may pursue to compare the period from 1970 to 1979 to the lost decade. Like the period from 1970 to 1979, investors during the 2000 to 2010 invested rapidly in alternative investments, especially gold, to offset real and perceived inflationary (or deflationary) pressure. To illustrate, from 1970 to its peak in 1980, gold shot up from $64 an ounce to $700. From 2000 to its peak in 2010, gold shot up from $285 an ounce to $1200. However, if history repeats itself, perceived inflationary (or deflationary) pressures will ease in 2012 and 2013, gold prices will see significant decline, and the media will subsequently coin the 2010 decade, “The Rise of Equities”. However, the rise of equities during the 2010 decade may not be as pronounce as that seen in the 1979 to 1989 rally, as the S&P 500’s earnings preceding the period from 2000 to 2010 experienced no growth, instead declining 6.27%. In light of this, the successful investor scours the market for quality businesses to invest in like McDonald’s, else be lost in the market with no return.

Lesson Learned 7: A lost market does not predicate that all stocks are lost.

8: Not All Stocks Bounce Back

When stocks decline in a broad market sell-off like what was witnessed from 2000 to 2002 or from 2007 to 2009; for the successful investor, it can certainly be exciting. However, he must dampen his emotion and analyze opportunities rationally. For example, in 2007, Citigroup’s stock was trading at $55, with a market capitalization of $275 billion. In 2010, Citigroup’s stock traded at $3.97, with a market capitalization of $115 billion. However, in restructuring its balance sheet, Citigroup issued 23 billion additional shares. If one were to calculate Citigroup’s market capitalization in 2007 with its 28 billion shares outstanding as of 2010, Citigroup’s value would be around $1 trillion, a value so overvalued it is frightening. Clearly, Citigroup faces extensive years of repair and a questionable future. To stress then is that not all stocks bounce back after market declines. Indeed, a stock will not bounce back if its underlying business is dead and will be dead for some time.

Lesson Learned 8: A fallen stock does not always spell opportunity.

9: 139 Years of S&P 500 Returns

From 1871 to 2009, the S&P 500 averaged consistently high returns; 10.59%. Further, throughout those 139 years, the S&P 500 delivered negative returns in 39 separate years while it delivered positive returns in the remaining 100. To illustrate, the S&P 500’s returns were negative 28% of the time while positive 72% of the time. The successful investor understands then that the market favours the long term investor. To emphasize, for every ten year period invested in the S&P 500, the successful investor expects positive returns for seven years and negative returns for three. Further, during those 139 years, the S&P 500’s largest gain was 56.79%, posted in 1933, while its largest decline was -44.20%, posted in 1931. The following table shows the S&P 500’s top ten positive returns and its top ten negative returns from 1871 to 2009.

Evidently, the S&P 500’s top ten positive returns, which average 46.34% and total 509.69%, outstrip its top ten negative returns, which average -26.42% and total -290.60%. In all, the successful investor understands that the stock market rewards those who are patient and disciplined. Sure he may lose 22% of his money one year, but the following year he may gain 56.79%.

Lesson Learned 9: The market rewards the patient and punishes the hasty.

10: Law of Averages

The stock market’s volatility is like a roller coaster; the twists and turns, peaks and valleys can be extreme. However, what the successful investor learned from each stomach-churning experience in the market, especially during the lost decade, made him a successful investor. To explain, over time the stock market will act in accordance to the law of averages in that stocks will fall drastically and rise dramatically. However, the stock of a quality business will consistently revert to its mean, moving upward, like what was exhibited in the S&P 500’s power trend line. The successful investor then understands that market declines are inherent in its upward trend. To accept the law of averages ensures one is well on his way to investing like the successful investor.

Lesson Learned 10: Ups and downs in the market retreat upward over the long term.

11: Emerging Industries

The successful investor adopted a “wait and see” approach to investing in emerging industries. To explain, during the 1900’s America’s core industries had just begun to grow. American brands we love today, such as Coca Cola or Pepsi, were rather obscure products from rapidly emerging industries. To hit home, during the early 1900’s, hundreds of automobile businesses existed in America. If an investor were to have invested in all those automobile businesses, 98% of his portfolio would have been destroyed by bankruptcies. Indeed, only three businesses emerged to the forefront of the American automobile industry: Ford, GM, and Chrysler. Fast forward to current day and green technology provides example of an emerging industry. However, out of those hundreds of green technology businesses, how does the successful investor pick future market leaders? Simply, the successful investor does not invest in green technology today; he waits until market leaders emerge and invests selectively tomorrow. As Gordon Gekko said, “I don't throw darts at a board. I bet on sure things.”

Lesson Learned 11: At birth, businesses come and go. At maturity, only the adaptable remain.

12: IPO’s and Spin-Off’s

The IPO, which stands for Initial Public offering, is avoided by the successful investor. First, an IPO is released to the common investor only after institutions have claimed blocks of shares for themselves at more attractive prices. Second, the release of an IPO to the market is usually followed by investor euphoria and so its price quickly inflates. Such was the case with Tesla Motors, an alternative energy automobile IPO, that shot up 12% in its first day of trading, declining 50% the next five days. An IPO is especially toxic if the offering business has no long term history or financial statements, like what was the case with Tesla Motors. To emphasize, the successful investor must know an IPO’s underlying fundamentals for he does not bet on a not-so-sure thing. Conversely, investing in a spin-off stock is a more-sure-thing than investing in an IPO. A spin-off is a business unit that a business divests from its core operations, perhaps for management to better pursue a units growth potential or to raise for it capital on the market. An example of an upcoming spin-off is that of Motorola’s wireless operations. At current, Motorola’s stock is comprised of several lagging units along with its relatively successful wireless unit, which is comprised of its popular Android powered mobile line. Parallel to the initial performance of an IPO, a spin-off stock will usually peak then decline. However, unlike an IPO, a spin-off stock declines for a different reason. For example, those investors holding Motorola’s stock would automatically receive Motorola’s Wireless stock once its spin-off completed. However, some Motorola shareholders may subsequently sell their Motorola’s Wireless stocks. Thus, the initial period following a spin-off stock’s debut is essentially a cleansing process, and in turn, a buying opportunity for the successful investor.

Lesson Learned 12: New stocks take time to find loyal owners.

13: Why a Stock Increases

The successful investor invests in a stock not based on its momentum, but on its underlying value, earnings, and future earnings potential. To emphasize, a stock’s price is driven by its growth over the long term. Logically, if earnings increase, a business will grow. For example, the successful investor would invest currently in Wal-Mart’s stock because he believes Wal-Mart’s market capitalization will be higher in 2040. While the successful investor cannot predict Wal-Mart’s future growth with utmost accuracy, he can with some certainty project its future growth based on its past growth. Thus, if by 2040, Wal-Mart triples its net income to $42 billion, Wal-Mart’s stock price, and in effect its market capitalization, should also triple to about $150 and $540 billion respectively, returning 10% compounded annually from 2010 to 2040. However, understand that a stock’s price increases in line with its underlying growth only in the long term. In the short term, a stock’s price increases in line with investor sentiment. As Ben Graham, the father of value investing, once said, "in the short run, the market is a voting machine, but in the long run it is a weighing machine.”

Lesson Learned 13: In the long term, a stock’s price increases in line with its underlying growth.

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LESSONS LEARNED

Market History

Lesson Learned 1: Through boom and bust, the market moves upward.

Lesson Learned 2: It’s not different this time.

Lesson Learned 3: Significant returns are got by investing at market nadir.

Lesson Learned 4: Invest during gloom, never sell, and ride the wave.

Lesson Learned 5: A sleeping stock will eventually be awoken by the growth beneath.

Lesson Learned 6: A dead market will revive; do not miss its return.

Lesson Learned 7: A lost market does not predicate that all stocks are lost.

Lesson Learned 8: A fallen stock does not always spell opportunity.

Lesson Learned 9: The market rewards the patient and punishes the hasty.

Lesson Learned 10: Ups and downs in the market retreat upward over the long term.

Lesson Learned 11: At birth, businesses come and go. At maturity, only the adaptable remain.

Lesson Learned 12: New stocks take time to find loyal owners.

Lesson Learned 13: In the long term, a stock’s price increases in line with its underlying growth.

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Chapter 2

BUSINESS VALUATION

“A small leak can sink a great ship.”

Benjamin Franklin

14: Book Value

A business’s book value is essentially its net value. To calculate book value, subtract a business’s total liabilities from its total assets. For instance, as of 2010, RIM’s assets totalled $10.2 billion while its liabilities totalled $2.6 billion. Thus, RIM’s book value is currently $7.6 billion. Moreover, annual growth in book value is necessitated as book value growth equates underlying business growth. For example, Warren Buffett measures the performance of his business, Berkshire Hathaway, by comparing its annual growth in book value to S&P 500’s annual growth in returns.

As one can deduct from the returns above, Berkshire Hathaway’s book value has grown rapidly. However, one should not regularly compare book value growth to that of Berkshire Hathaway’s as its growth is an extreme example. Ample book value growth is 5% or more annually. While book value has been examined, another variation exists; tangible book value. Tangible book value is calculated by subtracting goodwill and net intangibles from book value. Goodwill or net intangibles consist of, among other factors, a business’s brand value. Indeed, the successful investor usually includes regular book value in his analysis. However, he factors tangible book value in his analysis if he believes undue premium is being applied to book value via goodwill and intangible assets.

Current Ratio

To calculate a business’s current ratio, divide its current assets by its current liabilities. A figure in the range of 1.5 to 2.0 is healthy, whereas 2.0 to 2.5 is ideal. For example, Johnson and Johnson has a current ratio of 1.8 as of 2010. Moreover, a business’s current ratio is a clear indicator of its underlying health.

Asset to Liabilities Ratio

The asset to liabilities ratio is similar to the current ratio. However, the asset to liabilities ratio is calculated by dividing total assets by total liabilities and illustrates a bigger picture of business health. The same benchmark as the current ratio applies to the asset to liabilities ratio; a figure in the range of 1.5 to 2.0 is healthy, whereas 2.0 to 2.5 is ideal.

Lesson Learned 14: A growing book value means a growing business.

15: Dividends

A dividend is a slice of profit a business doles out to its shareholders. A Business that consistently distributes dividends during a long operational period most likely possesses a stable business model and disciplined management. However, dividends are counterproductive if a business is laden with an unsustainable balance sheet, a scenario that suggests either its business model is deteriorating or its management is inept. Be wary then, as investors who flock to a stock solely for its dividend will just as likely dump that stock if business fundamentals deteriorates further, since deterioration usually prompts a drastic dividend cut. For example, with toxic loans on its balance sheet as a result of the financial crisis, GE cut its dividend in order to fortify capital reserves. With no surprise, GE’s stock plummeted during that tumultuous period and has sputtered since. Conversely, Canadian banks maintained high dividends, a result of their relatively clean balance sheets, and in effect, enjoyed confident stock rebounds following the financial crisis. Moreover, for logical reason the successful investor does not limit his stock investments to businesses that pay dividends. To explain, businesses such as Google or RIM retain all earnings and reinvest those earnings to then return more. Thus, to dole out dividends would dilute Google or RIM’s internal growth. Another case in point is Berkshire Hathaway. Warren Buffet, its founder and CEO, has said that the day he cannot turn all Berkshire Hathaway’s retained earnings into more earnings is the day he starts distributing dividends. However, even given the example of RIM, Google, and Berkshire Hathaway, the successful investor finds that many quality businesses pay dividends consistently over the long term, perhaps a signal of both consistent and confident growth.

Lesson Learned 15: A dividend, while not always warranted, underscores the consistent business.

16: Earnings

The successful investor focuses on both a business’s net income and earnings per share (EPS). Moreover, net income and EPS must meet or surpass his strict standards over a period of ten years. Without analyzing earnings over the past ten years, it is difficult for the successful investor to project earnings into the future. Firstly, neither net income nor EPS should be negative in the past ten years. If there exists an outlier, only one year of negative earnings is allowed, but only if those earnings are extraordinary such that they resulted from a recession. Rationally then, a business with no negative earnings during the past ten years is favoured. Secondly, earnings must be growing, If not, the business in analysis is clearly failing to utilize its retained earnings to return greater earnings. As well, if earnings grow inconsistently, such as 10% one year, 50% the other and 1% the last, those earnings are volatile. Volatile earnings disable the successful investor’s ability to project future earnings growth. Thus, a quality business with consistently growing earnings is ideal. Finally, the successful investor employs a simple equation based on earnings to predict a stock’s future price. First, he averages the EPS growth rate of a business over ten years. Let us say that the average EPS growth rate is 8% for our hypothetical business. Second, he projects the future 5 years of EPS by applying the 8% growth rate. For our example, the fifth year produces projected EPS of $4.15. Third, the successful investor multiplies the 10 year average P/E ratio of the stock in analysis by its projected $4.15 EPS. For example, a hypothetical 15 P/E x 4.15 EPS is $62.25. Thus, the successful investor would expect that if EPS projections were correct, in five years the stock’s price in analysis would be $62.25. However, take note stock price projections are not absolute, as a business’s earnings may not grow at historical rate or the stock market may experience correction.

Lesson Learned 16: Earnings must fuel more earnings and those earnings must fuel more.

17: Revenue

A consistently growing revenue base is another essential facet of the quality business. Moreover, the successful investor analyzes a business’s ten year revenue trend. Firstly, revenue must be growing, at a rate decided upon by the investor. However, a growth rate of 5% is an ideal expectation. Secondly, revenue growth must be consistent. As with earnings, revenue growth should not be volatile but rather consistently growing. Otherwise, the investor cannot accurately project future revenue growth. Finally, one must assess whether a business has been able to grow its revenue during recession. Take the 2008 recession for example. If a business’s revenue grew in line with its historical growth rate during recession then that business is clearly perpetually relevant to its consumers.

Case Study: Notorious Revenue

A bad business is one that can only increase its profit by expanding its revenue base. For example, Dollarama is plagued by its business model. It sells $1 items, which means increases in its prices to grow profit would surely repel customers, and in result, hurt business. Thus, the only growth potential for Dollarama is in its ability to grow the number of Dollarama stores, which would inflate its revenue base, naturally expanding profit. The dollar store then is a business the successful investor avoids, as a competitor such as Wal-Mart possesses superior pricing power as it is not limited to selling $1 items to expectant customers.

Lesson Learned 17: Revenue should grow in any pasture, green and not so green.

18: Return on Equity

Return on equity (ROE) is calculated by dividing a business’s net income by its book value, also known as equity or shareholders equity. From our earlier example, RIM’s equity was $7.6 billion. On its income statement for 2009, one can find that RIM’s net income was $2,457 billion. $2,457 billion divided by $7.6 billion is 32%, RIM’s ROE for 2009. But what does ROE mean? Simply, ROE is the measure of income a business returns from its shareholders equity. To clarify, ROE is akin to the mutual fund manger pooling together $100,000 of his clients’ money, and in the first year, returning 10% or $10,000 of it. Equity in a business then is the shareholders stake. And naturally, each shareholder expects a business to utilize his stake to return income. Logically then, the successful investor is attracted to a business with high return on equity, for he wants his money invested where return is greatest. Do not be mistaken however; returns on equity are not literally returned but reinvested into the business. In RIM’s case, its returns are used to reinvest largely in its technology, capital, and operations, while transferring a portion to cash holdings in case lawsuits emerge over its patents. Indeed, the successful investor invests in businesses with consistently high ROE because ROE is a precursor to business growth. Palm, a market darling of years past, posted consecutively negative return on equity, which was no surprise, however, given its inability to adapt. Clearly, Palm’s shareholders’ equity would have been better invested with RIM. Again to stress, while the successful investor invests in a business with high return on equity, he does not invest in a business with inconsistent return on equity. Generally speaking, a business with consistently high return on equity – ranging from 12% to 50% - will grow immensely long term, with its stock price close in tow as that business builds value for its shareholders.

Lesson Learned 18: Your money invested must see ample return; else why invest your money?

19: Profit Margin

The successful investor invests in a business with consistently high profit margins. Profit margin is calculated by dividing a business’s net income by its revenue. A consistently high profit margin sends a clear signal that the business in analysis is near impenetrable. Otherwise, competitors would have already entrenched on that business; increasing competition via pricing, and in effect, eroding profit margins in the industry. For example, Coca Cola has long retained profit margins around 20% because no competitor has thus far been able to entrench on its business model. Indeed, the successful investor invests more favourably in a business with profit margins ranging consistently from 5% to 35% and higher.

Lesson Learned 19: A high profit margin underlies the impenetrable business.

20: Debt

A business with debt nearing 60% of its market capitalization is a sinking ship. As of 2010, GE’s long term debt was $377 billion, comprising 240% of its $156 billion market capitalization. Given that staggering figure, the successful investor would not invest in GE as he understands substantial long term debt is a burden to any business. One can measure a business’s ability to manage its debt burden by comparing its net income to its long term debt. The question is; can a business pay down efficiently its long term debt with solely its net income? With GE’s current $11 billion net income, it would take thirty four years to pay down its long term debt, without taking into account the income needed to operate GE. Conversely, RIM currently has zero long term debt on its balance sheet. Indeed, the successful investor likes best the business with little or zero long term debt.

Lesson Learned 20: Significant debt is a heavy anchor for any business.

21: Cash

Cash holdings are a double edged sword. A business with plentiful cash is cushioned from a hit. Conversely, that surplus cash may be better distributed to shareholders via a special dividend payout or deployed to buy back shares. However, the successful investor appreciates a business that holds surplus cash for good reason as that business can theoretically cover its long term debt if need be. For example, as of 2010, Johnson and Johnson held $16 billion in cash, whereas its long term debt stood at only $8 billion. Clearly, Johnson and Johnson not only possesses an ideal business model that produces significant earnings for growth, but also the ability to retain a fraction of its earnings to cover any long term debt if need be.

Case Study: Unlocking Cash Value

Manulife Financial is North America’s largest and the world’s fourth largest insurance business. Although Manulife Financial’s main operations are located in North America, it controls significant operations in Asia, spanning ten countries there. And while the successful investor values highly Manulife Financial, the common investor currently does not. Manulife Financial, as of July 2010, traded with a historically low P/E of 7.49. The common investor feels that because Manulife Financial did not hedge its segregated funds before the financial crisis, that each stock market correction will effectively hammer it. However, Manulife Financial’s portfolio consists of quality holdings; real estate in Canada, USA and Asia totalling $6 billion, stock’s totalling $5.3 billion, and money market funds and bonds totalling billions. Finally, even as Manulife Financial increasingly hedges its segregated funds, targeting a 70% hedge by 2012, common investor sentiment is “too little too late”. However, by comparing Manulife Financial’s underlying business to that of Great-West Life Co, another Canadian insurance business, one should conclude Manulife Financial’s stock is grossly undervalued.

First, Manulife Financial’s $29 billion book value is higher than its $28 billion market capitalization. Evidently, the successful investor can buy a piece of Manulife Financial for no premium. Second, Manulife Financial’s cash holdings and investments are substantial. Manulife Financial’s management is clearly maximizing its float - the money it receives from policy holders that is then invested or held in cash holdings. And overall, Great-West Lifeco’s fundamentals pale in comparison to those of Manulife Financial. However, Great-West Lifeco’s market capitalization falls only $4 billion short of that of Manulife’s. Further, because Manulife Financial is not trading with a premium, the successful investor would unlock its cash value. As of 2010, Manulife Financial held $19 billion in cash holdings, which comprised 68% of its market capitalization and 66% of its book value. However, before unlocking Manulife Financials cash value, the successful investor would take into account its $6 billion in long term debt. The equation to unlock Manulife’s cash value helps valuate Manulife Financial’s real stock price:

Manulife Financial’s real stock price = actual stock price [$15] + (cash per share [$10.8] – long term debt per share [$3.52])

Finally, the equation delivers Manulife’s real stock price, $22.28, an increase of 49% over its actual $15 stock price.

Lesson Learned 21: Cash is king.

Checklist: Evaluating a Business for Advantage

1. Brand. The business must possess a readily identifiable brand with favourable consumer perception.

2. Growth. The business must be able to grow its market share domestically and/or globally.

3. Track Record. The business must have a track record; else one cannot project its future.

4. Relevancy. The business must be relevant in multiple markets in that the business can expand its products into varying countries with ease.

5. Management. The business must possess able managers that focus on building shareholder value by; maintaining high return on equity, buying back shares, and owning personal stake in the business.

6. Competitive Advantage. The business must possess such a strong competitive advantage that other businesses fail to entrench on its market.

7. Earnings. The business must be growing its earnings over time.

8. Pricing Power. The business must be able to increase prices over time in line with inflation or greater.

9. Return on Equity. The business must enjoy high return on equity. Otherwise, it is not building shareholder value.

10. Consistency. The business must be consistent. The inconsistent business changes with the wind.

11. Profit Margin. The business must generate consistently high profit margins.

12. Personal Appeal. The business must appeal to you. You must love to such an extent its products or services that you can endorse the business without hesitation.

13. Book Value. The business must be growing its book value and, in turn, its underlying value.

14. Simplicity. The business must be selling a product or service that anyone can understand.

15. Repeat Use. The business must sell a product or service that is purchased consistently and continuously by the consumer.

16. Utility. The business must possess lasting utility such that underlying its brand, its products or services satisfy a consumer need or want.

17. Market Leader. The business must be a market leader. The market leader enjoys little competition.

18. Consumer Base. The business must enjoy a large consumer base, preferably both domestically and globally, so that it is not plagued by volatile revenues.

19. Employee Morale. The business’s employees must be happy to work there. A happy top line creates a better bottom line.

20. Adaptability. A quality business must be relevant forever by understanding how to sell in future markets.

21. Self Growth. The business must not grow by financing credit but instead grow by effectively allocating its retained earnings.

22. Debt. The business must not be burdened by significant long term debt, otherwise risk staggered growth.

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LESSONS LEARNED

Business Valuation

Lesson Learned 14: A growing book value is a growing business.

Lesson Learned 15: A dividend, while not always warranted, underscores the consistent business.

Lesson Learned 16: Earnings must fuel more earnings and those earnings must fuel more.

Lesson Learned 17: Revenue should grow in any pasture, green and not so green.

Lesson Learned 18: Your money invested must see ample return; else why invest your money?

Lesson Learned 19: A high profit margin underlies the impenetrable business.

Lesson Learned 20: Significant debt is a heavy anchor for any business.

Lesson Learned 21: Cash is king.

***

Chapter 3

COMPETITIVE ADVANTAGE

“We provide food that customers love, day after day after day. People just want more of it.”

Ray Croc

22: Competitively Advantaged

The successful investor only invests in a business with clear competitive advantage. Warren Buffett depicted competitive advantage as a moat, whereby competitors could not breach it to penetrate a business’s fortress. A business enjoys competitive advantage by creating a strong brand, possessing pricing power, offering niche customer service, or operating in an oligopoly, among others. In effect, a competitively advantaged business attracts and retains loyal customers. For example, Coca Cola is widely consumed as a result of its strong brand recognition. If one were to receive $1 billon from a venture capitalist, would he be able destroy Coca Cola’s market share in the soft drink industry? Absolutely not. Similarly, Wal-Mart is widely known to have the lowest prices in the industry. Consumers flock loyally to Wal-Mart, not Zellers. To stress then is that the successful investor invests in competitively advantaged businesses because he knows consumer loyalty to those businesses is like an addicts addiction; predictable and virtually impossible to break. Moreover, most favourable, however difficult to find, is a business that enjoys several competitive advantages.

Case Study: Competitive Advantage of a Strong Brand

Establishing competitive advantage in the clothing retail industry is incredibly difficult, which is why malls are so popular. Consumers likely visit multiple stores in order to find a top or pair of jeans, demonstrating no loyalty to one store. These clothing retailers then operate much like commodity businesses. However, there are juggernauts in the clothing retail industry. These juggernauts strategically established luxury brand appeal, a clear competitive advantage, to ensure consumer loyalty. For example, some consumers consistently seek Gucci, Coach or Louis Vitton products. Price is no barrier. One will never find a 60% off sale for a Gucci purse because there are people that will pay $500 for a Gucci purse, time and time again.

Case Study: Competitive Advantage of Pricing Power

The successful investor does not invest in a business with little or no pricing power, for he knows one of the most detrimental forces to a business is inflation, which can average 3% annually. A business that can raise its prices annually by more than inflation, such as Starbucks, is then competitively advantaged. Could McDonald’s harness the same pricing power for its coffee that Starbucks enjoys? Absolutely not. And yet, in 2008, common investor sentiment was McDonald’s new McCafe would rapidly entrench on Starbucks core business model. The successful investor shrugged off this negative sentiment, however, for he knew Starbucks customers well, reasoning they would not migrate to McDonald’s coffee based solely on lower prices. The common investor also discounted Starbucks during the financial crisis, forecasting consumers would tighten their belts and forever spend less, in turn declaring Starbucks doomed with its $5 Frappuccino. However, the successful investor simply visited several Starbucks locations to discover business was booming.

Case Study: Competitive Advantage in Niche Customer Service

North West Company Fund manages a portfolio of general department stores that, with the exception of one, most have likely never heard of: Northern, North Mart, AC Value Centre, and Giant Tiger. Aside from Giant Tiger, these department stores operate in the remote, northern regions of Canada. Indeed, North West Company Fund possesses clear competitive advantage in that no other business wants to operate in those remote regions of Canada. From this, North West Company was able to develop a strong relationship with its primarily Native Canadian customers. Further, selling to Native Canadians ensures North West Company almost guaranteed growth since the Canadian government subsidizes the income of Native Canadians. In essence then, North West Company consistently collects that government subsidized income when Native Canadians shop at its stores.

Case Study: Competitive Advantage of the Oligopoly

Canadian banks are undoubtedly the world’s most secure banks. The big five – TD, RBC, CIBC, ScotiaBank and BMO – weathered the storm that was the financial crisis from 2007 to 2009. Canadian banks are secure because its management is disciplined. For instance, investments are cautiously pursued, complex derivatives are largely avoided, mortgage policies are stringent, and most importantly, Canadian banks do not employ cowboys with itchy trigger fingers, unlike U.S. banks. However, Canadian banks charge high fees on accounts, chequing, withdrawals, over draft, trades, and the list goes on. And yet, in Canada, the majority of residents hold their money in either one of the “big five” banks, which is clearly the banks’ competitive advantage. Indeed, the Canadian banking system is essentially an oligopoly, an excellent reality for shareholders of a Canadian bank, not so excellent a reality for customers. Intelligently, the successful investor hedges the impact of high Canadian bank fees by becoming a shareholder in one of the “big five”.

Lesson Learned 22: Only invest in those businesses with clear competitive advantage.

23: Competitive Advantage is Relative

McDonald’s is, without question, wildly successful in the western world. Most Westerners have learned to love Big Macs. However, the successful investor understands competitive advantage is relative. To illustrate, McDonald’s enjoys clear competitive advantage in the Western world. However, this advantage does not translate to the Eastern world. To explain, McDonald’s is a distant #2 fast food restaurant in China, with only 1,100 locations as of 2010 compared to KFC’s more than 2,950. The reason for McDonald’s #2 position in China is its strength in the West: beef burgers. Evidently, the Chinese do not like beef burgers as much as they do chicken. Compounding KFC’s competitive advantage of simply being in the business of selling finger licking good chicken, it customizes its food for the local Chinese market. As a result, KFC has gained enormous popularity in China to such an extent that children can be seen dressed like Colonel Sander’s; he is an iconic symbol in China. Indeed, the successful investor understands that competitive advantage is relative. Success is not predetermined, and as a result, McDonalds’ management cannot expect to successfully superimpose its business model the world over. Luckily then, the successful investor is at benefit in Canada, for he can ask those people from countries like China about the appeal a business like KFC had in their former homeland. Strategically, the successful investor interviews consumers of a product, taking management discussion with a grain a salt. Indeed, management will tell you what you want to hear whereas the consumer will tell you how it is.

Lesson Learned 23: A competitive advantage in one setting may not be a competitive advantage in another.

24: Dow and TSX 60

The following is a list of businesses contained in the Dow Industrial Average Index. These 30 businesses possess near impenetrable competitive advantages.

Business Name

3M CO

ALCOA INC

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