Wednesday, 8 October 2014

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School

When you are considering buying growth stocks:
1.  Verify the existence of a franchise
2.  Earnings return is 1/P/E.
3.  Identify cash distribution in terms of dividends and buybacks
4.  Identify investment return of retained earnings
5.  Identify organic (low investment growth)
6.  Compare to the market (representing D/P & growth rate) - is this positive or negative?

I will give you the numbers from three years ago which we applied to a bunch of firms.  
We will look at WMT, AMEX, DELL and GANNETT. 

Company        Business                                                   Adjusted ROE
WMT              Discount Rate                                             22.5%
AMEX            High-end CC                                              45.5%
Gannett           Local NP & Broadcasting                          15.6%
Dell Direct      P/C Supply & Logistics Organization       100% 

Company          Sources of CA                          Local Economies of Scale
WMT                Slight customer captivity            Yes
AMEX              customer captivity                       Some
Gannett             customer captivity                        Local
Dell                   Slight customer captivity             Yes 

Perspective Return on the US Market 

(1) 6% return based on (1/P/E) plus 2% inflation = 8%
(2)  2.5% (Dividends/price) plus 4.7% growth = 7.2% return 

Expected Return equals 7%.   Range is 7% to 8%.  

Wal-Mart. Dell, Gannett and AMEX.

If you are thinking of investing in them, what do you want to know first? 

Is there a franchise here?
  • Does WMT have CA? Yes, regional dominance and it shows up in ROE, adj. for cash of 22%. 
  • Amex is dominant in their geographic and product segments. Amex dominates in high end credit cards.  
  • Gannett is in local newspapers. ROC is 15.6% if you took out goodwill then ROIC would be 35% or higher.  -- 
Ross: CA can’t be just sustained, allow to grow.  CA, EOS and CC.  
Do you think different type of CA are better for allowing you to grow.  They are therefore worth looking at?  Are those franchises sustainable. 
With WMT there is some customer captivity in retail but there are big local and regional Economies of Scale.
  • When WMT goes outside these Economies of scale they have no advantages. 
  • If they go against competitors outside their regional dominance, they will be on the wrong side of the trade.  
AMEX dominates high end credit cards. 
  • Do they have customer captivity? 
  • (Note: Amex has been using more and more debt to generate high ROE, so the risk profile is higher). 
Comparison to the Market
  • They track well because if you look at reinvestment returns, it is high because people are not investing a lot in equities. 
  • Look at organic growth which is higher than it is today. 
  • On the other hand, multiples have gone up. 
  • There has been a secular increase in multiples of 1% to 2%.
  • You have to ask yourself, is it reasonable to earn a 7% to 8% return on equities in the present climate where long bonds are earning 4%?  Historically the gap has been 8%.  
Should you use a cost of equity of 7% to 9% vs. 9% to 11%.  I think that we are talking about real assets.  That is a good question. 
  • One of the things you want to do is use a lower cost of capital than 9%.
  • But all of a sudden all these stocks have EPV well above their asset values. 
  • Now some of that will be in intangibles.
But what should be happening?  Investment should be going up, but they are not.
  • So it looks like for practical purposes with a market multiple of 16 and 2x book value, the real returns are significantly lower than that.  
  • So if you have the opportunity to invest in businesses with returns greater than that, you want to value the income streams at 9% to 11% rather than 7% to 9%. 
Amex is trading back at 17 times.  Growth rate at 15%.  A classic growth stock.
  • A 6% return. 
  • They are committed to returning 6% to shareholders, but the 6% cash distribution will be 4%.
  • They are reinvesting 2%.
  • We know what they are doing with that money. They are lending it to their customers, by and large.            


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