we’re trying to be conservative with respect to what we can sell the stock for 10 years from today.

if future estimated earnings per share is $2.00 and future P/E is 20, someone will buy our shares for $40 each. but if that future P/E is a lower 15, then the market would only give us $30 per share.

regarding estimating the growth rate, there are of course a large variety of ways to do this and you should use what you trust! the CFA program teaches a sort of top-down approach (what is the economic outlook for this region of the world, this industry in this region of the world, this sector of this industry in this region of the world, …).

but i don’t consider myself a good enough economist (yet) to trust my economic forecasts. so i do as i believe you’re suggesting, compute a “best-fit” curve over the historical data and extrapolate it out to the future. and i tone down the growth rate a bit if the historical computes out to be something i think is unreasonable, like 45%.

- lumi

and about the growth rate, shouldn’t we look how the growth for a specific company is? (linear,avg,exp.) and then try to forecast upcoming growth, to be more reliable on data.

Just my thoughts!

Here is some information that I hope will steer you toward what you’re looking for.

First, my source for this is Trade Like Warren Buffett. In chapter 2 the author says that Buffett’s investing style is a mixture of Philip Fisher and Ben Graham. But Fisher advocated a “focused” portfolio of just a few stocks you can easily follow, research and manage, whereas Graham-Dodd advocated more extensive diversification.

Which does Buffett subscribe to? To answer that, the author reprints a famous Buffett quote:

“Wide diversification is only required when investors do not understand what they are doing.”

The author goes on to say that there are two excellent books on the value of such “focused” portfolios and lists these two by Hagstrom:

The Warren Buffett Portfolio
The Essential Buffett

Finally, he says that academic research in this area received a boost from the following paper:

“On the Industry Concentration of Actively Managed Mutual Funds”, by Clemens Sialm, Lu Zheng, and Marcin Kacperczyk, Journal of Finance, 2005

If you google the paper title, you’ll come across a few links with the PDF.

Below is the abstract:
Mutual fund managers may decide to deviate from a well-diversified portfolio and concentrate their holdings in industries where they have informational advantages. In this paper, we study the relation between the industry concentration and the performance of actively managed U.S. mutual funds from 1984 to 1999. Our results indicate that, on average, more concentrated funds perform better after controlling for risk and style differences using various performance measures. This finding suggests that investment ability is more evident among managers who hold portfolios concentrated in a few industries.

The abstract does not detail conclusions about beating the market as a whole, and perhaps suggests that “focused” does not mean few stocks, but few industries. But this seems to be the main source that the author is citing. If you read the whole 50-page PDF, I’d be interested to know your conclusions!

-Lumi

Could you point me to the study on highly concentrated portfolios you’re talking about? Studies usually point out that actively managed portfolios don’t beat the market over the long run…

Thanks!

Thibaut

To paraphrase, in a study looking at mutual fund returns over 1984-1999, the conclusion was that actively managed, but highly concentrated portfolios tended to perform better than funds with diversified portfolios. What’s more, the they tended to outperform the market too, despite previous findings that actively managed funds in general, underperform the market.

This is attributed to the “information advantage” that the concentrated portfolio manager has – able to closely track and understand the businesses of his few holdings. No chance in doing that with a 200-stock diversified portfolio.

And that was a good reminder for me on GE. I tend to equate old, large-cap businesses with being easy to understand. Not always so.

Thanks again for your thoughts.

- Lumi

I want to add a few things to your write up, if you don’t mind.

1) When using this strategy, your confidence level won’t be as great relative to using the standard DCF valuation. As soon as you purchase your desired stock, there will be sleepless nights. Because of this, you might start to second guess 1) the method 2) your input numbers ie.. 15% of Req of Rtrn 3)Yourself (not good as a confidence builder).

So what will you do then? Revert back to DCF valuation. Or stick to Indexing.

When Markets are going up, the above scenario might not occur (sleepless nights). Because all strategie during a bull mkt. are good strategies.

It’s when we have a bear mkt that we find out if our strategy is any good.

From my experience, the best strategy is to FULLY understand the company you will invest in. Picture yourself as the CEO. Analyze every line in the Fin. Stmnt. Analyze competition, industry trends, vendors/suppliers, Customer wants and needs. More importantly, invest in a company you would be interested in running/owning, and that you can fully, easily understand. So, a G.E is out of the question for an avg. investor. Unless, you think you can run the many divisions of G.E.

Even if you have to invest in just ONE company, it’s a good start. As a matter of fact, for an avg. investor, probably the best way to invest, is to start with 1 or 2 stocks. Gradually increase your holdings or find other firms. But do not invest more than 5 companies at a time. You will not have time to go through all the readings of the 10k and other reports. Think of the entrepreneur who risk quitting their day job to start a small business. That’s how an avg. investor should think, except the quitting the job part. You might be best serve writing a business plan for the Company you want to invest in. Once, you have determined that it is safe to invest, I would do what Warren Buffett does, GO BIG, ALL IN, if you have too. Charlie Munger once commented that Berkshire was really built on no more than 10 decisions (investments)! That would be Coke, Americ. Express, Washington Post, Geico, I forget the rest…

If you don’t think you can run the business (not day-to-day ofcourse) or understand it’s many facets, then indexing is the way to go. And at times like we have now, learn how to hedge your bets with options. Good Investing to ALL!

I try to put in an hour a day but probably average 45 minutes instead. I’ve actually been surprised at how little time it takes to make it through each volume – reading each page and working each problem once.

But one pass is of course nowhere near enough to internalize enough to pass so I’m counting on having a few months to review well.

Hope to keep good enough notes to have a full record of all logged hours before exam day.

- Lumi

How many hours a day or if this fluctuates wildly how many hours a week do you try and put in for studying?