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Morningstar's 10 Small Companies to Invest in Now.
by: Paul Larson
- Format: pdf
- Pages: 22
- Publisher: Wiley (October 14, 2009)
- Language: English
- ASIN: B002U3CBYI
ReviewA downloadable guide to investing in some of today-s most-promising smaller companiesInvestors are always on the look-out for new opportunities. This special digital report from Morningstar-s Paul Larson, equities strategist and Morningstar StockInvestoreditor, reveals 10 lesser-known companies worth investigating.
Everyone knows about Coca-Cola. But how many investors know how to seek out the next Coca Cola? With this timely report, Morningstar-s Larson shares some of his favorite investing gems, and introduces you to some great companies you-ve probably never heard of.
- Includes an introduction that discusses how Larson selected these companies
- Contains individual company analysis written by the Morningstar analyst that covers that respective company
- Provides relevant statistics to the investment decision-fair value price, P/E, and much more
Product DescriptionThree Keys to Choosing Stocks
By Paul Larson
Equities Strategist and editor, Morningstar StockInvestor
When researching stocks, I don-t focus on short-term trends. Instead, I-m interested in finding high-quality stocks for the long term.
I focus on:
+ A company-s economic moat
+ Its fair value
+ Its margin of safety
Moats
The concept of an economic moat can be traced back to legendary investor Warren Buffett, whose annual Berkshire Hathaway BRK.B shareholder letters over the years contain many references to him looking to invest in businesses with -economic castles protected by unbreachable -moats.--
Whenever a company develops a profitable product or service, it isn-t long before other firms try to capitalize on that opportunity by producing a similar-if not better-version. Basic economic theory says that in a perfectly competitive market, rivals will eventually eat up any excess profits earned by a successful business.
In other words, profits attract competition, and competition makes it difficult for firms to generate strong growth and margins over an extended period of time.
Investors run into especially big trouble when they underestimate the effects of competition by assuming that a company-s prospects are more sustainable than they truly are.
I encourage investors to look for firms that have a sustainable competitive advantage-not just an interesting new product, but rather unique assets that can truly stand the test of time.
Fair Values
At Morningstar, we use a proprietary discounted cash-flow (DCF) model to derive fair value estimates. This model assumes that the stock-s value is equal to the total of the free cash flows the company is expected to generate in the future, discounted back to the present at a rate commensurate with the riskiness of the cash flows. In contrast, Wall Street target prices are usually formulated by taking a short-term earnings estimate and applying a multiple, most typically a price/earnings (P/E) ratio. In theory, the P/E ratio shows how much investors are willing to pay for a firm-s earnings. To arrive at a target price for the future, sell-side analysts often take their earnings projections and multiply them by a P/E ratio that they believe other investors will pay in the future.
However, what something is worth is not always the same as what someone is willing to pay for it. Our fair value estimates are meant to provide a calculation of what the stock is worth, irrespective of what investors are willing to pay for it.
Margins of Safety
The phrase -margin of safety- goes back to the legendary value investor Benjamin Graham, who called it -the key concept of investment.- Margin of safety is the major factor I use to judge whether a stock is a -buy- at a given price.
For Graham and Dodd, a stock-s margin of safety is the amount by which its intrinsic value exceeds its market price. So, if a stock is worth $40 a share but it-s selling for $30, its margin of safety is $10, or 25% of its intrinsic value. Graham thought a stock was worth buying as an investment only if it had a margin of safety big enough to compensate for the possibility that his intrinsic value estimate was too optimistic.
How far below its fair value estimate does a stock-s price have to go before it becomes an attractive investment for me? I first assume that not all margins of safety are created equal. A young, very risky company whose future cash flows are hard to predict will require a bigger margin of safety than a dominant, well-established company in a stable industry, such as PepsiCo PEP. The larger discount compensates for the increased chance that something will damage the young firm-s growth and profitability (such as new competitors) and for the greater possibility that our fair value estimate will turn out to be too optimistic.
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