Friday, 24 October 2014

Tesco: Expect full-year adjusted earnings per share (EPS) of 15.15p and about the same in 2015, says Deutsche.

Deutsche Bank has cut estimates for the second-half and for the full-year. The broker now expects full-year UK profit of £814 million, 23% less than previous estimates, and 13% less in Asia, driving annual group profit down 45% to £1.8 billion. In 2011, it was almost £4 billion. Expect full-year adjusted earnings per share (EPS) of 15.15p and about the same in 2015, says Deutsche.

At 174p, Tesco shares trade on 11.5 times forward earnings. That’s expensive given the ongoing price war will likely continue to crush UK margins, and without any guidance either on profits, or strategy. Much will be expected from the January statement. Until then, it’s difficult to see any positive catalysts.

Thursday, 16 October 2014

What is capitulation?

What is capitulation? CNBC Explains

Traditionally, the word capitulation describes a surrender between fighting armies. What is capitulation when it's used on Wall Street? What does it signify? We explain.

What is capitulation?

In simple terms, capitulation is when investors try to get out of the stock market as quickly as possibleand look for less risky investments. It's also described as panic selling. It's usually based on investor fears that stock prices will fall further than they have.

Capitulation is usually signaled by a decline in the markets of at least 10% in one day.

In getting out of the market, investors give up any previous gains in stock price. That means they take a financial loss, just to get out of stocks. The thinking is: take a smaller loss now rather than a bigger one later.

Real capitulation involves extremely high volume-or high numbers of traded shares-and sharp declines in stock prices.

Why do investors capitulate?

Suppose a stock starts dropping in price. There are two choices. Investors stick it out and hope the stock begins to appreciate-or they can take the loss by selling the stock.

If the majority of investors decide to wait it out, then the stock price will probably remain stable. But if the majority of investors decide to capitulate and give up on a stock, they start selling and that starts a sharp decline in a stock's price.

Are there any benefits from capitulation?

Only for those buyers ready to swoop in. After capitulation selling, common wisdom has it that there are great bargains to be had in the stock market. Why? Because everyone who wants to get out of a stock, for any reason, has sold it. The price should then, theoretically, reverse or bounce off the lowest price of the stock.

In other words, some investors believe that capitulation is the sign of a bottom and a chance to get stocks at a cheaper price than before the capitulation took place.

Is capitulation a way to gauge the markets?

Not at all.Capitulation is very difficult to forecast and use as a way to buy or sell stocks. There is no magical price at which capitulation takes place. Certainly during the trading day, stock prices and volumes are monitored and some measurement is used to determine if a capitulation is taking place and will remain so at the end of the day.

But most often, investors and market watchers look back to determine when the markets actually capitulated and see how far stocks have fallen in price for that one day of trading.

When have there been capitulations?

The stock market crash of 1929 that helped lead to the Great Depression, is a capitulation. In fact, it had more than one day of it.

On Oct. 24, 1929-what's known as Black Thursday-share prices on the New York Stock Exchange collapsed. A then-record number of 12.9 million shares was traded.

But more was to follow. Oct. 28, the first "Black Monday," more investors decided to get out of the market, and the slide continued with a record loss in the Dow for the day of 38 points, or 13 percent.

The next day, "Black Tuesday," Oct. 29, 1929, about 16 million shares were traded, and the Dow lost an additional 30 points.

More recently, there was a massive sell off or panic selling of stocks on Oct. 10, 2008, in what can be considered a capitulation. Not only U.S. stocks, but global markets had major declines of 10 percent or more on one day.

Investors flooded exchanges with sell orders, dragging all benchmarks sharply lower. It's believed fears of a global recession and the U.S. housing slump sparked the sell-off.

Sunday, 12 October 2014

Slow and steady doesn't make headlines, but the company can continue to earn excellent returns on invested capital.

CTB operates worldwide in the agriculture equipment field.  Berkshire purchased it in 2002 and by 2009, it has picked up six small firms.

Berkshire paid $140 million for the company.  In 2008, its pre-tax earnings were $89 million.

Vic Mancinellis, CEO of CTB, an agricultural equipment company, one of Berkshire's boring manufacturing businesses, exemplifies another reason for optimism.

Since Buffett bought CTB in 2002, it has earned roughly an average 11 percent annual return, compared to the S&P return of only 3 percent.

How can such a basic business produce eye-popping results?

It wasn't through financial innovations or game-changing acquisitions.   Instead, Mancinelli focussed on "blocking and tackling, day by day doing the little things right and never getting off course:"

Ten years from now, Vic will be running a much larger operation and, more important, will be earning excellent returns on invested capital.

But slow and steady doesn't make headlines.  Investors approaching the stock market continue to put their money in the hare, not the tortoise.

Betting on tortoises can create long-lasting wealth.

Goodwill. Understand the "cost" of goodwill.

Goodwill is an accounting term that describes the dollars paid to buy a business over and above its book value.  Goodwill is a real number, but it tells us nothing about the future earning power of a business.

Berkshire owns some terrific businesses.  Many of them were purchased, however, at large premiums to net worth - point reflected in the good will item shown in its balance sheet.  In year 2008, its balance sheet reported a goodwill of US 16,515 millions.  The company earned an impressive 17.9% on average tangible net worth in 2008, but if goodwill was included, this reduced the earnings to 8.1%.

Buffett paid more for these businesses because he expects them to earn gobs of money in the future.  In this happy event, the goodwill number is not relevant.

However, if increased earnings don't materialize, the amount of goodwill will weigh on the earnings of a business.  How will this affect investor returns?

By including the amount paid for goodwill in the return calculation, Buffett clearly reports the "cost" of goodwill.

In 2008, Berkshire investors got a return of only 8.1% on their total net worth, including goodwill, compared to a return of 17.9% on tangible net worth, excluding goodwill.

Most large U.S. companies have large amounts of goodwill reported on their balance sheets.  This information is important to know.  If companies pay more for acquisitions than the future earnings these ventures produce, investors will be harmed.

Saturday, 11 October 2014

Ignore the noises that rattle the markets. A conclusion about the economy does not tell us if the stock market will rise or fall.

In 75% of those years (from 1965 to 2008), the S&P stocks recorded a gain.   You can guess that a roughly similar percentage of years will be positive in the future too.Can you predict the winning and losing years in advance?  I don't think anyone can.

The economy was in shambles throughout 2009, but that did not tell us whether the stock market will rise or fall.

A conclusion about the economy does not tell us if the stock market will rise or fall.

Understand accounting allows you to understand how companies create value.

To better understand the wealth-producing advantages of the businesses, you have to understand accounting and the "vastly different" financial reporting characteristics of various businesses.

Accounting, just like eating spinach, may not be what you want, but it sure is good for you.  :-)

A little patience brings great rewards.  You can learn something important about each business and can also use your knowledge to understand how other companies create value.

You want to be informed, confident and loyal in your investing.

Buffett: See's Candies - A Great, Not Just a Good, Business

Buffet never forgets that growth is good, but only at a reasonable cost.

In 2007, See's Candies sold 31 million pounds of chocolate, a growth rate of only 2 percent.  What does Buffett see that other misses?

1.  He paid a sensible price for the business.
2.  The company enjoys a durable competitive advantage:  Its quality chocolate is bought by legions of loyal customers.
3.  It is a business he understands.
4.  It has great managers.

But See's Candies possesses one more attraction.  It throws off cash and requires very little capital to grow. 

Here is Buffett explaining See's value proposition in his 2007 shareholder letter:

" We bought See's [in 1972] for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million.  The capital then required to conduct the business was $8 million.  (Modest seasonal debt was also needed for a few months each year.)  Consequently, the company was earning 60% pre-tax on invested capital.  Two factors helped to minimize the funds required for operations.  First, the product was sold for cash, and that eliminated accounts receivable.  Second, the production and distribution cycle was short, which minimized inventories.

Last year See's sales were $383 million, and pre-tax profits were $82 million.  The capital now required to run the business is $40 million.  This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth - and somewhat immodest financial growth - of the business.  In the meantime pre-tax earnings have totalled $1.35 billion.  all of that, except for the $32 million, has been sent to Berkshire."

Buffett uses See's cash to buy other attractive businesses

"Just as Adam and Eve kick-started an activity that led to six billion humans, See's has given birth to multiple new streams of cash for us.  (The biblical command to "be fruitful and multiply" is one we take seriously at Berkshire.) .. There's no rule that you have to invest money where you've earned it.  Indeed, it's often a mistake to do so:  Truly great businesses, earning huge returns on tangible assets, can't for any extended period reinvest a large portion of their earnings internally at high rates of return."

But a company like slow-growing See's is rare in corporate America.  In order to grow earnings like See's, CEOs in other businesses typically would need "to invest $400 million, not the $32 million" that See's required.  Why is this true?  Because most growing businesses "have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments."  Not so at See's.

Buffett opines that the great business, like See's, is like a savings account that "pays an extraordinarily high interest rate that will rise as the years pass." 

See's is not just the candy.  To Buffett, the company is a chocolate-powered cash machine.

Additional notes:  Great, Good and Gruesome Businesses of Buffett

Capital Allocation and Savings Accounts

Buffett compares his three different types of great, good and gruesome businesses to "savings accounts." 

The great business is like an account that pays an extraordinarily high interest rate that will rise as the years pass.

A good one pays an attractive rate of interest that will be earned also on deposits that are added.

The gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Bill Gross: Financial markets are artificially priced. Discounting of future profit streams by an artificially low interest rate results in corresponding high P/E ratios. Real estates are affected in the same way.

bill gross

Financial markets are artificially priced. In the bond market, there is nothing normal about a three year German Bund yielding a “minus” 10 basis points. Similarly, UK Gilts and U.S. Treasurys have in recent years never experienced such low yields and therefore high prices. The same comparison can be applied to stocks. While profits in many cases are at record highs, the discounting of future profit streams by an artificially low interest rate results in corresponding high P/E ratios. Real estate cap rates, which help to price homes and commercial shopping centers, are affected in the same way. While monetary policy with its Quantitative Easing and forward guidance for low future interest rates have salvaged a semblance of growth and job gains – especially in the U.S. – they have brought prosperity forward in the financial markets. If yields can’t go much lower, then bond market capital gains are limited. The same logic applies in other asset categories. We have had our Biblical seven years of fat. We must look forward, almost by mathematical necessity, to seven figurative years of leaner: Bonds – 3% to 4% at best, stocks – 5% to 6% on the outside. That may not be enough for your retirement or your kid’s college education. It certainly isn’t for many private and public pension funds that still have a fairy tale belief in an average 7% to 8% return for the next 10 to 20 years! What do you do?

Well the obvious advice on a personal level: Retire later, save more, accept a revised standard of living. But the financial advice varies with your age and willingness to take risk. Younger investors with a Texas Hold’em “all in” attitude could push all of their chips onto the equity table. Boomers nearing retirement probably cannot afford to. A lengthy bear market could force them permanently out of the game. So, one size does not fit all here. It never has.

What might be applicable for most generations, however, is an “unconstrained strategy” that I managed well for the past few years at PIMCO and which now provides me the opportunity for 100% of my time at Janus. An unconstrained strategy sounds very open-ended, and it is. But it allows a professional and experienced investment firm like Janus to select the most attractive alternatives across many asset categories while hopefully diminishing the risk of bond and stock bear markets. The strategy seeks to protect principal while providing an acceptable return in this low yielding, low returning world that I have just described. Unconstrained investors should expect a shorter average maturity for bonds; an ability to profit from currency movements currently taking place with the euro and the yen fits the description as well; taking advantage of what is known as “optionality” and investing in what I have successfully applied in the past with what is called “structured alpha,” would be an important component too. The simple explanation of an unconstrained strategy:

Take your best ideas within the context of a low duration/short maturity portfolio and try to help investors achieve what they consider to be an acceptable return. Watch the fees as well.

Whatever your risk/return persuasion, whether it be stocks, bonds, unconstrained, real estate, or “other,” an “intelligent investor” (as initially described by Benjamin Graham in the late 1940s) should be aware that returns almost necessarily cannot equal the magnificent prior decades that some of you might have experienced during my days at PIMCO. But I/we look forward, with the same intensity and “client comes first” attitude that led to my second marriage at Janus. James Bond famously said that “you only live twice.” I hope to emulate Mr. Bond as Janus Denver and Janus Newport Beach link hands and ideas to improve your financial balance sheet, and ultimately provide a better life for you and your family. Perhaps you only dance twice too. Sue and I would like that.

24 of the most profitable companies return an average of 573% in a decade

It might seem simple, but if you pick stocks based on earnings, you will be a winner

Bloomberg News/Landov Gilead Sciences (CEO John C. Martin) has been the most profitable of S&P 1500 member companies in health care over the past six months. Its stock has returned 431% in three years. 
The best-run companies tend to have the widest profit margins. So how does that translate into stock-price performance?
The short answer is that they are superior bets.
But first, there are several types of profit margins. For example, the gross margin is the difference between net sales and the cost of sales, divided by net sales. That measures the profitability of a company's core business, leaving out general expenses, interest, depreciation, taxes, amortization and other items. It is a useful measure to track companies' progress over time.
A conglomerate such as General Electric Co. (GE) will report an €œindustrial margin, which excludes its financial business, and will even break down a separate margin for each of its lines of business.
Depending on the sector or industry, certain margin measures may not be available. But the net income margin is net income divided net sales or revenue is a common measure available for every profitable company.
So we developed a list of highly profitable companies, using components of the S&P 1500. We picked the top three in the 10 broad market sectors by net income margin over the past 12 months, as calculated by FactSet.
Here they are, with the sectors in alphabetical order:
Most profitable S&P 1500 companies across 10 sectors
Company Ticker Location Sector Net income margin - past 12 months
PulteGroup Inc. (PHM) Bloomfield Hills, Mich. Consumer Discretionary 46.50%
Iconix Brand Group Inc. (ICON) New York Consumer Discretionary 36.10%
Priceline Group Inc. (PCLN) Norwalk, Conn. Consumer Discretionary 27.96%
Philip Morris International Inc. (PM) New York Consumer Staples 26.60%
Altria Group Inc. (MO) Richmond, Va. Consumer Staples 24.31%
Brown-Forman Corp. Class B (BF-B) Louisville, Ky. Consumer Staples 22.12%
Gulfport Energy Corp. (GPOR) Oklahoma City Energy 51.83%
Approach Resources Inc. (AREX) Forth Worth, Texas Energy 30.05%
Atwood Oceanics Inc. (ATW) Houston Energy 28.92%
Capstead Mortgage Corp. (CMO) Dallas Financials 76.49%
LTC Properties Inc. (LTC) Westlake Village, Calif. Financials 56.54%
RenaissanceRe Holdings Ltd. (RNR) Pembroke, Bermuda Financials 54.02%
Gilead Sciences Inc. (GILD) Foster City, Calif. Health Care 42.64%
Anika Therapeutics Inc. (ANIK) Bedford, Mass. Health Care 36.20%
Edwards Lifesciences Corp. (EW) Irvine, Calif. Health Care 35.70%
Delta Air Lines Inc. (DAL) Atlanta Industrials 27.84%
Union Pacific Corp. (UNP) Omaha, Neb. Industrials 20.58%
ITT Corp. (ITT) White Plains, N.Y. Industrials 19.81%
Verisign Inc. (VRSN) Reston, Va. Information Technology 57.43%
Visa Inc. Class A (XNYS:V) Foster City, Calif. Information Technology 44.65%
MasterCard Inc. Class A (MA) Purchase, N.Y. Information Technology 37.14%
CF Industries Holdings Inc. (CF) Deerfield, Ill. Materials 31.44%
Royal Gold Inc. (RGLD) Denver Materials 26.41%
Sigma-Aldrich Corp. (SIAL) St. Louis Materials 18.59%
AT&T Inc. (XNYS:T) Dallas Telecommunications 13.75%
Verizon Communications Inc. (VZ) New York Telecommunications 12.50%
Atlantic Tele-Network Inc. (ATNI)   Beverly, Mass. Telecommunications 11.78%
Aqua America Inc. (WTR) Bryn Mawr, Pa. Utilities 26.92%
OGE Energy Corp. (OGE)   Oklahoma City Utilities 17.59%
Questar Corp. (STR) Salt Lake City Utilities 14.46%
Source: FactSet
A look at total returns (through Tuesday) for those groups of companies tells an interesting story:
Total returns 
Company Ticker Total return -   YTD Total return - 3 Years Total return - 5 years Total return - 10 years
PulteGroup Inc. PHM -10% 359% 83% -25%
Iconix Brand Group Inc. ICON -8% 135% 204% 785%
Priceline Group Inc. PCLN -5% 137% 537% 4,878%
Philip Morris International Inc. PM 0% 46% 109%
N/A Altria Group Inc. MO 24% 96% 244% 627%
Brown-Forman Corp. Class B BF.B 17% 103% 217% 382%
Gulfport Energy Corp. GPOR -22% 108% 481% 1,186%
Approach Resources Inc. AREX -31% -28% 47%
N/A Atwood Oceanics Inc. ATW -21% 18% 18% 225%
Capstead Mortgage Corp. CMO 11% 50% 63% 181%
LTC Properties Inc. LTC 10% 73% 107% 277%
RenaissanceRe Holdings Ltd. RNR 3% 66% 89% 130%
Gilead Sciences Inc. GILD 39% 431% 360% 997%
Anika Therapeutics Inc. ANIK -2% 505% 490% 156%
Edwards Lifesciences Corp. EW 61% 47% 207% 531%
Delta Air Lines Inc. DAL 29% 357% 331%
N/A Union Pacific Corp. UNP 28% 155% 300% 729%
ITT Corp. ITT -1% 209% 182% 268%
Verisign Inc. VRSN -8% 85% 171% 206%
Visa Inc. Class A V -6% 147% 205%
N/A MasterCard Inc. Class A MA -12% 137% 252%
N/A CF Industries Holdings Inc. CF 23% 118% 238%
N/A Royal Gold Inc. RGLD 39% 4% 40% 329%
Sigma-Aldrich Corp. SIAL 45% 124% 168% 432%
AT&T Inc. T 4% 43% 76% 119%
Verizon Communications Inc. VZ 4% 56% 130% 119%
Atlantic Tele-Network Inc. ATNI -2% 89% 19% 504%
Aqua America Inc. WTR 3% 53% 103% 135%
OGE Energy Corp. OGE 11% 65% 161% 319%
Questar Corp. STR -1% 32% 113% 267%
S&P Composite 1500 Index 5% 78% 104% 115%
Total returns assume the reinvestment of dividends.
Source: FactSet
This hasn't been such a good year for the group, with only 12 of 30 beating the 5% total return for the S&P 1500. But over longer periods, the story changes.
Over three years, 17 have beaten the index, and 14 have more than doubled.
For five years, 21 have beaten the S&P 1500, with 10 more than doubling the performance of the index.
Going out 10 years, all but one of the 24 companies (six haven't been publicly traded that long) have beaten the index. The average return is 573%, compared with 115% for the S&P 1500.

So being highly profitable provides protection against the type of decline that took so much out of the index during 2008 at the height of the credit crisis.
Philip van Doorn covers various investment and industry topics. He has previously worked as a senior analyst at He also has experience in community banking and as a credit analyst at the Federal Home Loan Bank of New York.

Three categories of businesses based on the cost of business growth: Great, Good and Gruesome

Buffett uses a simple checklist to determine the attractiveness of businesses as investments.  To meet his tests, companies must possess:

1.  a sensible price tag
2.  durable competitive advantages
3.  business he can understand
4:  managers who have integrity and who are passionately involved in their business creations.

Even though he is not involved in the day-to-day operations, Buffett pays close attention to how much cash each business generates.  He determines how much is needed to maintain a rate of appropriate growth and how much can be invested elsewhere to build intrinsic value in the Berkshire enterprise.

In his 2007 shareholder letter, Buffett offered a capsule view of how he assess companies based on their capital allocation profiles.  He sorts businesses into three categories based on the cost of business growth great, good, and gruesome.  This sorting allows him to see sizzle where others cannot.

Friday, 10 October 2014

Buffett devotes his precious time to reading and thinking, looking for gaps in values that others miss.

In 1999, after 34 years in business, Berkshire had a market capitalization that positioned it as the 74th largest American company.  Yet it had no Wall Street research coverage.  In 1999, Alice Schroeder, a Paine Webber research analyst, wrote the first Wall Street research report on Berkshire. 

Buffett continues to rely on his managers to run their day-to-day business operations.  he continues to devote precious time to reading and thinking.  Like a miner panning for gold, he sifts data from newspapers, annual reports, and other publications, looking for gaps in values that others miss. 

Analysing the substance and character of a business is the holy grail of investing. Guessing a price that someone else is willing to pay, is not.

By 1969, the stock market had reached new highs, and the Buffett Partnership continued to beat its returns.  As the market continued to climb even higher, Buffett announced that he would close his partnerships.  He told the partners that the speculation-driven stock market didn't make sense; he wanted no part of the folly.

Buffett sold everything in the portfolio except for shares in Diversified Retailing, Blue Chip Stamps, and Berkshire Hathaway, which now included insurance and banking businesses as well as equity investments.  Avoiding the speculative market, Buffett continued to hunt for attractive underated businesses.  In 1971, he bought a controlling interest in See's Candies.

By early January 1973, the Dow had climbed to an all time high of 1,051 points But only $17 million of Berkshire's $101 million insurance portfolio was invested in stocks; the rest was in bonds.  Not long after this high, the market swooned.  The it racheted down further.  By October 1974, it hit a low of 580 points.  Investors panicked but Buffett rejoiced.  He was in his elements once again.

Over the following years, Buffett bagged big game at  bargain prices, adding Wesco Financial and buying large blocks of stocks in The Washington Post and Geico.  In 1977, Buffett bought The Buffalo News. 

Buffett's belief that analysing the substance and character of a business was the holy grail of investing.  Guessing a price that someone else was willing to pay - irrespective of fundamentals - was not.

Cinderella at the Ball. Warning investors about the "sedation of effortless money".

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs.  Nothing sedates rationality like large dose of effortless money.  After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball.  They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring on pumpkins and mice.  But they nevertheless hate to miss a single minute of what is one helluva party.  Therefore, the giddy participants all plan to leave just seconds before mid-night.  There's a problem, though:  They are dancing in a room in which the clocks have no hands. 

Warren Buffett's Cinderella parable in his 2000 shareholder letter.

In a financial crisis, when banks cannot lend, cash is particularly valuable.

Buffett is a balance sheet guy.  That's where the cash is reported.  Cash is the fuel that drives economic value.

Most CEOs, however, focus on growth in corporate profits more than on cash and balance sheet growth.  The source of the problem is:  some of the reported expenses in these income statements are cash, and some are determined by accounting rules.  As a result, earnings include both cash and noncash (i.e., "accounting") numbers.  Buffett cares most about the cash part.

Cash is real.  Noncash earnings are subject to accounting interpretations.  They can be adjusted to inflate earnings and boost the stock price.  But it is harder to fiddle with the cash numbers.

Buffett's long-term cash obsession creates unique opportunities that others miss.  Buffett keeps a lot of cash on hand in order to be ready for unique crisis-born opportunities.  "Do we panic when the price of filet mignon drops?  No, we rejoice.  Who wouldn't want to buy the highest-quality steaks at chopped meat prices?"

At the end of June 2008, cash represented just over 11 percent of Buffett's balance sheet.  He used some of it to provide high-cost financing for then top-credit-rated companies Goldman Sachs and GE, both desperately in need of cash.  He announced his biggest acquisition to date - buying the Burlington Northern Santa Fe Railway for $34 billion.  At $100 a share, he paid a reasonable, but not a cheap, price.

Why Buffett decides not to pay out dividends in 45 years in Berkshire Hathaway?

He has been able to reinvest Berkshire's profits at rates considerably higher than Berkshire's investors could have earned y reinvesting them in the market. 

When the company can no longer meet the test of reinvesting $1.00 of EPS to create $1 of additional value, then, says Buffett, Berkshire will pay dividends, and let his owner-partners reinvest the cash.

Ask yourself this ONE question, every time a stock price goes up or down.

Every time a stock goes up or down, you should ask yourself:

Is this price movement based on changing fundamental or changing sentiment?

Sometimes the answer is not so obvious. 

In such a situation, here is a good guiding principle.

It is better to be approximately right than to be exactly wrong.

Thursday, 9 October 2014

Essentials of Value Investing

The Intelligent Investor by Benjamin Graham and Greenwald’s Book: Value Investing from Graham to Buffett and Beyond.

Class Case Studies

This is a class in a specific kind of investing. There are two basic approaches. There are short-term  investors (preferably not investing taxable money). Many technical investors who do not care about the underlying quality of the companies invest solely on price information. Although some value investors build a time element into their investments. There are investors who look at short-term earnings. Analysts spend their time on earnings’ forecasting. If you think IBM is going to do $1.44  vs. the analyst estimates of $1.40, then you buy IBM, because analysts are behind the real growth in earnings. Your estimate is correct.

Another group, who has given up altogether, they believe the markets are efficient; they index.  Unless the distribution is very skewed, then only 50% of the investors can outperform the market. This is a market for long-term investors with a particular orientation (value investors). You look at a security and it  will represent a claim on earnings and assets. What is that claim worth? If you think that a company is worth $22 to $24 per share, then you look to buy with a margin of  safety. When the margin of safety is sufficiently large, you will buy. You will look for bargains.

Value Investors constitute only 7% of the investor universe. There is substantial statistical evidence that value investing works: higher returns with lower risks than the market.

Value Investing (“VI”) rests on three key characteristics of financial markets:

1. Prices are subject to significant and capricious movements that can temporarily cause price to diverge from intrinsic value. Mr. Market is to offer you various prices, not to guide you.  Emotionalism and short-term thinking rule market prices in the short-run.

2. Financial assets do have underlying or fundamental economic values that are relatively stable and can be measured by a diligent and disciplined investor. Price and value often diverge.

3. A strategy of buying when prices are 33% to 50% below the calculated intrinsic value will produce superior returns in the long-run. The size of the gap between price and value is the "margin of safety

We put someone (into business with a value formula that has averaged 20% plus returns over the past four years. He will be on the show, Imposter!

The preponderance of evidence is overwhelming for value investing as a good approach.
1. Statistical evidence
2. Performance evidence of big value funds (Oakmark, Third Avenue, Fairholme, Tweedy Browne)
3. Relatively episodic evidence that a disproportionately large amount or percentage of successful investors follow the value approach.

All human beings have certain predispositions that hurt themselves and prevent them from following 
the value approach.

Essentials of Value Investing
Long-term - Fundamental (Look at Underlying Businesses)
Specific Premises
(1) Mr. Market is a strange guy - prices diverge regularly from fundamental values
(2) You can buy under priced Stocks - fundamental values are often measurable
(3) Fundamental value determines future price - Buying under priced stocks plus patience implies superior returns.
Patience helps create time arbitrage between short term focus and long-term values.

Why Value Investing works. Buying cheaply works.


Markets are not Efficient
All you should worry about since you aren’t going to be able to outguess the market is minimizing transaction costs, and allocating assets that creates an appropriate risk profile. What I think you ought to know about that is two things.

  • The first is that there is overwhelming statistical evidence that markets are not efficient. In all countries and all periods of time since the early 20th century, that there are variables that can be reliably used to outperform the market and that clearly contradicts the premise that nobody can outperform the market. 
  • There is a sense in which absolutely and fundamentally markets are efficient and it is this—that when we buy as night follows the day someone else is selling that stock thinking it is going down--and one of you is always wrong. (Don’t play the patsy!)

Why Are You on the Right Side of the Trade?
Another way of saying that is not everybody can outperform the market. The famous humorist called Garrison Keiller talks about a fictional town called Lake Woebegone. In Lake Woebegone all the women are beautiful, all the men are tall and all the children are above average. In this game all the children are average on average which means half of them underperforms the market. So when you start to think about investing, you must be able to answer the question:

  • Why are you able to beon the right side of the particular trade? 
  • Why are you the one who is right, and the person who is trading with you is wrong? That is the most fundamental aspect of Investing. 
  • Where and what is your investing edge? 
  • What puts you on the right side of the trade?

Buying Cheaply Works
When we talk about value investing there is a lot of evidence that value investors have been on the
right side of the trade. 

  • The statistical studies that run against or contradict market efficiency almost all of them show that cheap portfolios—low market-to-book, low price-to-book—outperform the markets by significant amounts in all periods in all countries—that is a statistical, historical basis for believing that this is one of the approaches where people are predominantly on the right side of the trade.  And, of course, someone else has to be on the wrong side of the trade.
  • Those studies were first done in the early 1930s; they were done again in the early 1950s. And the ones done in the 1990s got all the attention because the academics caught on. There is statistical evidence that the value approaches—buy cheap securities—have historically outperformed the market.  Buying Cheap works.

Value Investing in Practice: Search strategy, Valuation strategy and Patience

Value Investing in Practice

Long-term - Fundamental (look at underlying business)

(1) Look intelligently for value opportunities (Low P/E, M/B)
o Mr. Market is not crazy about everything
o This is the first step not to be confused with Value Investing

(2) Know what you know
 Not all value is measurable
 Not all value is measurable by YOU (Circle of Competence)

(3) You don't have to swing    PATIENCE

Value Investing: the Approach

Search (Look Systemically for under valuation) -->Value --> Review --> Manage Risk 

 Value implies concentration not diversification. (Look for a Margin of Safety)

 At worst Buy the Market)



Look intelligently for value opportunities. You must have search strategies. Every time you sell stock, someone else is buying that security. Vast majority—95%--is selling because the stock will go down versus buying because the stock is going up. You seek a seller that is motivated by psychological imperatives other than the underlying value. One person on one side of the trade is always wrong. 

Trust me--that will be the case (with you) in big tech stocks that are covered by 100s of analysts. YOU have no advantage or edge.

Where will I look for opportunities? Where I will be the smart one on the side of this trade? You have to decide what type of investing you want to do in this realm. In every case, they pursue in concentrated fashion a particular niche strategy or specialty within the value area.

You have to know what you know and what you don’t know.

 Not all value is measurable *
 Not all value is measurable by you.
 Where do I have the advantage?
 Where am I the smart money? *

* Critical for one to determine

Great investors focus on specific opportunities in concentrated ways. They are very disciplined by staying within their circle of competence.

I (Bruce C. Greenwald) used to sit on panels of money managers who managed foundations' money. Some money managers would say that they are close to MSFT and we know what it will do. Thank God I am not that stupid. MSFT is impossible to value. Much of the value is in the future of the future (think of the large amount of estimation in the terminal value of Disc. Cash Flow). 85% of the value of MSFT will come in the years 2010 to 2020!

How much of the investment in 2000 you get back by 2010—15%. The other 85% value of MSFT is beyond 2010—(2010-2020)! Lots of luck. No one can do that. Then they say they can do it for complicated companies like Citicorp and GE? Forget it.

Understand what valuations are fundamentally impossible. Stay away from those glamour stocks.

If you try to be an expert in everything, you will be an expert in nothing. You can specialize in small stocks, highly complicated situations, or a specific industry or country.

When you say you know what it is worth, you better know better than the rest of the investors in the community.


You want an approach, a valuation procedure and a discipline that will restrict you to making decision on the basis of what you really know. You are betting against the person on the other side of your trade. Where is your edge?


You have to be patient. Mr. Market throws a pitch every day, but you only have to swing at the ones that are in your sweet spot. THE FAT PITCH IN YOUR STRIKE ZONE.

Patience is rewarded especially when you are on the other side of impatient money.


They run up the score whether you swing or not, and you are being judged by the other scores. You are being judged relative to the market.

What is your default strategy when there is nothing to do? Buy the market in an index fund vs. cash. What does the absence of opportunity tell you?

If you think DCF is the best way to value companies, then you will have a problem.

In practice, you want to look intelligently for value opportunities, a valuation strategy that identifies what you really know, and you want an appropriate default strategy for managing risk.

All the elements have to be in place. Valuation strategy must be appropriate to your search strategy. You always have to track what you do. Have you lost money on this type of stock before? If you have made a mistake before, be aware of it. Be aware of the market and what other intelligent investors are doing. If you think Wells Fargo is overvalued, you want to think carefully about selling if Warren Buffett is on the other side.

Reviewing these judgments.

How do you manage risk? How do you put together a portfolio? A more concentrated portfolio requires better patience and valuation. Think about the underlying economic reality.

In general, stocks have outperformed all other assets. Default strategies and investing in indexes and having a balanced strategies. One value investor said cash was better than an index strategy. Test: Read through great value investors' letters when they have mostly cash vs. having the money in an index over the next three years, the results were so discouraging to his hypothesis. The index outperforms cash.

In 1986, Bill Ruane went into cash and thought the market was over-valued. Think of an equity bias.

Another lesson, you can hedge out the risk of the stock market as a whole at a low price. Historically, that has not been a good strategy. Look at the market as a whole and it would influence your allocation between cash and an index.

Notes from video lecture by Prof Bruce Greenwald



1.  Prices and Intrinsic Values Regularly Diverge

  • If prices are fluctuating a lot and you think fundamental values are stable and the evidence is in favor of that too. Then Prices are going to diverge regularly from fundamental value.

2.  You Can Measure Some Fundamental Values

The second assumption is more problematical: it is that you can identify which stocks are trading above or below their fundamental values.

  • That means fundamental values have to be measurable and that is by no means always the case especially by you. 
  • To give you a simple example of that, I sit on panels where we advise the managers of charitable trusts who invest money in the United States and invariably it is me and a bunch of people who sell money management services,and they all talk about how good they are at evaluating or estimating the value of stocks like Microsoft. And this was back when Microsoft was trading at 70 times earnings when it was at $110 a share. This was in the year 2000.And I thought, thank God I am not that type of Jackass who has to pretend to be able to do that. 
  • Because the truth of the matter is that the value of Microsoft doesn’t depend upon what happens in the next ten years because the dividend return you will get will be at most 15% of the value of the stock. 
  • So what you are pretending what you can do is being able to forecast what MSFT will look like in the year 2010 and from then on. If you do that, lots of luck. So it is not clear, but we are going to talk about cases where it is true and where you can do it. 

Price and Values will Converge

Then another article of faith is ultimately the fundamental values will out. If you hold it long enough, you will get superior returns and the market prices of these stocks will return, and there is some evidence that is the case.

  • When you try to put this into practice, what it means is first of all, because most, not all, will not be strikingly under or overvalued if you are thinking of going short. 
  • You have to look Intelligently for things that you are going to value. 
  • Then when you estimate values, you have to be rigorous about knowing what you know. 

Not all values are measurable (as in the Microsoft case.)

  • And much more importantly as Warren Buffett has recently proved—though he is the most successful investor in history, but as he has recently proved with respect to silver and the value of the dollar--not everybody is an expert in everything. 
  • You are not going to be good at valuing everything. 
  • You have to concentrate on what your own particular circle of competence is. 

3.  Search for Opportunities

The third idea is that you look Intelligently for opportunities.
  • You are rigorous about valuing those opportunities and then you have to be patient. 
  • And Buffett tells a little story where he says, ― Investing is not like baseball where you have to swing at every pitch. You don’t have to swing, they can throw as many pitches as you want, and you still don’t have to swing. 
  • Value investing implies concentration not diversification. 
  • Because you can be patient, you want to wait for your pitch. 
  • That is the good news. 

The bad news is that any professional investor knows--they run up the score whether you swing or not. 

  • Because you are being compared to indices. 
  • Because you have to have some reasonable strategy for what you are going to do when there is no obvious opportunity in these two categories. 

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School
Edited by John Chew at studying/teaching/investing Page 7

Where do you always want to start a valuation?


Asset Valuation 

Where do you always want to start a valuation?  You want to start with assets.  Why?  Because they are tangible.  You could technically go out and look at everything that is on the firm’s balance sheet. Even the intangibles like the product portfolio you could investigate it today without making any projections or extrapolations.  You could even investigate the quality of things like the trained labor force and the quality of their business relationships with their customers (I think this is very difficult to ascertain). 

Start with that. It is also your most reliable information. It is also all that is going to be there if this is not a viable industry, because if this is not a viable industry, this company is going to get liquidated.  And what you are going to see is the valuation in liquidation. And that is very closely tied to the assets.   In that case, with that strategic assumption, you are going to go down that balance sheet and see what is recoverable.  But suppose the industry is viable, suppose it is not going to die. How do you value the assets then? Well, if the industry is viable then sooner or later the assets are going to be replaced so you have to look at the cost of reproducing those assets as efficiently as possible.   So what you are going to do is you are going to look at the reproduction value of the assets in a case where it is a viable industry.  And that is where you are going to start. We will go in a second and a little more tomorrow about the mechanics of doing that reproduction asset valuation. But that is value that you know is there.  

Earnings Power Valuation

The second thing you are going to look at because it is the second most reliable information you are going to look at is the current earnings. Just the earnings that you see today or that are reasonably forecastable as the average sustainable earnings represented by the company as it stands there today.   

And then we are going to extrapolate.  We are going to say suppose there was no growth and no change what would the value of those earnings be? Let’s not get into the unreliable elements of growth. Let’s look secondly at the earnings that are there and see what value there is. And that is the second number you are going to calculate and the likely market value of this company.  But it turns out that those two numbers are going to tell you a lot about the strategic reality and the likely market value of this company.  


Suppose this is a commodity business like Allied Chemical and you have looked at the cost of reproducing the assets.  And you think you have done a pretty good job at that—And you could build or add buildings, plants, cash, accounts receivables and inventory that represents this business-- customer relationships, a product line--for a billion dollars.  This is usually going to be the cost for their most efficient competitors, who are the other chemical companies.  So the cost of reproducing this company is a billion dollars. Suppose on the other hand its earnings power is $200 million, and its cost of capital is 10% so the value of it s earnings which mimics its market value is two billion dollars ($200 million/0.10).  What is going to happen in that case?  Is that  two billion $ going to be sustainable?   $2 billion in earnings power value (EPV) is double the asset value (AV) of the company but there are no sustainable competitive advantages. If EPV is > than AV, then sustainability depends upon franchise value (“FV”). 

Well, think about what is going on in the executive suites of all these chemical companies. They are going to seed projects where they can invest $1 billion dollars and create two billion dollars of value.  What these guys love better than their families are chemical plants.  So you know those chemical plants are going to get built if there is not something to prevent that process of entry.

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at                           
studying/teaching/investing Page 24 

Additional notes:

Reversion to the Mean or the Uniformity of One Price 

As the chemical plants get built, what is going to happen to this chemical price?  It is going to go down. The margins will decline, the earnings power value and the market value of the company will go down. Suppose it goes down to a $1.5 billion.  Will that stop the process of entry?  No, not at all. Because the opportunity will still be there.  (Profits still above the cost of capital) 

In theory, the process of entry should stop when the cost of reproducing those assets equal the market value of those assets.  In practice, of course, it is easier to buy a puppy than to drown it later.  Once those puppies are bought, you are stuck with it.  The process of exit is slower than entry.   The same thing applies to chemical plants.  Once those chemical plants are built, they are likely to stay there for a long time.  Typically, the process may not stop there.  It applies equally to differentiated products. Suppose Ford, to reproduce their assets of the Lincoln division is $5 billion and the earnings power value and the market value is 8 billion. What is going to happen then?  Mercedes, the Europeans and the Japanese are going to look at that opportunity, and they are going to enter. 

Now do prices necessarily fall?  No, not in this case, they match Ford’s price. What will happen to Ford’s sales?  Inevitably they are going to go down because they will lose sales to the entrants.  What therefore will happen to their unit fixed costs?  The costs will rise.  Their variable costs are not going down, so their unit costs are going up.  The prices are staying the same, their margins are going down and their per units sold and their sales are going down, so what happens to profits here with a differentiated market and with a differentiated product?  Exactly the same thing.  

The differentiated products won’t save you. And that will go on until the profit opportunity disappears.  Unless there is something to interfere with this process of entry, sooner or later the market value of the company will be driven down to the reproduction value of the assets.  Especially, in the case of the Internet. You had companies that didn’t have any earnings that were $5, $10 or $15 billion dollars whose assets could be reproduced for $10 million or $15 million dollars.  Unless there is something to stop the process of entry, the earnings to support that are not going to materialize.  So what you are looking at is a decline.

Asset value (AV) and Earnings power value (EPV). Know the 3 scenarios - AV > EPV, AV = EPV and AV < EPV

What you have got then is two pictures of value: 

1. You have got an asset value
 2. You have got an earnings power value
And now you are ready to do a serious analysis of value. If the picture looks like case A (AV > EPV), what is going on assuming, you have done the right valuation here? If it is an industry in decline, make sure you haven’t done a reproduction value when you should be doing a liquidation value.  What it means is say you have $4 billion in assets here that is producing an equivalent earnings power value of $2 billion. What is going there if that in the situation you see?  It has got to be bad management.  Management is using those assets in a way that can not generate a comparable level of distributable earnings.  

AV is Greater Than EPV 
  • In this case the critical issue—it would be nice if you could buy the company—but typically you pay the reduced EPV and all that AV is sitting there.
  • Then you are going to be spending your time reading the proxies and concentrating on the stability or hopefully the lack of stability of management. 
  • Preeminently in that situation, the issue is a management issue. 
  • The nice thing about the valuation approach is that it tells you the current cost that management is imposing in terms of lost value.  That is not something that is revealed by a DCF analysis. And there are a whole class of value investments like that.
  • One of the great contributions to the theory of this business is Mario Gabelli’s idea that really what you want to look for in this case is a catalyst that will surface the true asset value.
  • You can wait and sometimes that catalyst may be Michael Price or Mario Gabelli if they own enough of the company.  I would like to encourage those investors who are big enough to make that catalyst you.  
AV Equals EPV 
  • The second situation where the AV, the reproduction value of the assets = EPV are essentially the same.
  • That tells a story like any income statement or balance sheet tells a story.  It tells a story of an industry that is in balance.  
  • It is exactly what you would expect to see if there were no barriers-to- entry. 
  • And if you look at this picture and then you analyze the nature of the industry—if you say, for example, this is the rag trade and I know there are no competitive advantages—you now have two good observations on the value of that company. 
  • If it ever were to sell at a market price down here, you know that is what you would be getting. You are getting a bargain from two perspectives: both from AV & EPV so buy it. 

EPV in Excess of AV 
  • We have ignored the growth, but I will talk about it in a second#. The last case is the one we really first talked about. You have got EPV in excess of AV. 
  • The critical issue there is, especially if you are buying the EPV—is that EPV sustainable?
  • That requires an effective analysis of how to think about competitive advantages in the industry.

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at                           
studying/teaching/investing Page 26

 Notes from video lecture by Prof Bruce Greenwald

Related topic: #
Look at growth from the perspective of investment required to support the growth. Profitable Growth Occurs Only Within a Franchise.

Two pictures of value: An asset value and an earnings power value.

Mechanically Doing a Valuation 

1.  Doing an asset valuation

Now, doing an asset valuation is just a matter of working down the balance sheet. 
  • As you go through the balance sheet, you ask yourself what it costs to reproduce the various assets.
  • Then for the intangibles list them like the product portfolio and ask what will be the cost reproducing that product portfolio. 
2.  Doing an Earnings power valuation

For the EPV, you basically have to calculate two things:  
  • You have to calculate earnings power which is the current earnings that is adjusted in a variety of ways.
  • You divide the normal earnings by the cost of capital.
There is an assumption in an earnings power value and part of it is being careful about what earnings are.  This is just a picture of what some of those adjustments look like.
  • You have to adjust for any accounting shenanigans that are going on, you have to adjust for the cyclical situation, for the tax situation that may be short-lived, for excess depreciation over the cost of maintenance capital expense (MCX).
  • And really for anything else that is going on that is causing current earnings to deviate from long run sustainable earnings.
  • So valuation is calculated by a company’s long-run sustainable earnings multiplied by 1/cost of capital.  
What you have got then is two pictures of value: 
1. You have got an asset value  (AV)
2. You have got an earnings power value  (EPV)
And now you are ready to do a serious analysis of value.
If the picture looks like case A (AV > EPV), what is going on assuming, you have done the right valuation here? 
  • What it means is say you have $4 billion in assets here that is producing an equivalent earnings power value of $2 billion.
  • What is going there if that is the situation you see? It has got to be bad management. 
  • Management is using those assets in a way that cannot generate a comparable level of distributable earnings.
  • If it is an industry in decline, make sure you haven’t done a reproduction value when you should be doing a liquidation value

Notes from video lecture by Prof Bruce Greenwald

Look at growth from the perspective of investment required to support the growth. Profitable Growth Occurs Only Within a Franchise.

Now to summarize about growth:
  1. growth at a competitive disadvantage destroys value,
  2. growth on a level playing field neither creates nor destroys value, and
  3. it is only growth behind the protection of barriers to entry that creates value.

The standard view of short term analysts is that growth is your friend. Growth is always valuable.  That is wrong!  
Growth is relatively rarely valuable in the long run. And you can see why with some simple arithmetic.  I am not going to look at growth from the perspective of sales, I am going to look at it from the perspective of investment required to support the growth. 
  • Now the investment required to support the growth is zero then of course it is profitable—that happens almost never (For Duff & Phelps or Moody’s perhaps). 
  • At a minimum you have A/R and other elements of working capital to support growth. 
Suppose the investment required is $100 million, and I have to pay 10% annually to the investors who supplied that $100 million dollars.   The cost of the growth is 10% of $100 million or $10 million dollars.   

1.  Suppose I invest that $100 million at a competitive disadvantage. 
  • Suppose I am Wal-Mart planning to compete against a well-entrenched competitor in Southern Germany, am I going to earn 10% on that investment?  Almost never.  In that case, I will be lucky to earn anything; perhaps I earn $6 million. 
  • But the net contribution of the growth is the $10 million cost of the funds minus the $6 million benefit which is minus $4 million dollars for every $100 million invested. 
  • Growth at a competitive disadvantage has negative value.  
2.  Suppose it is like the automotive industry or like most industries with no barriers to entry, it is a level playing field so the return will be driven to 10% cost by the entry of other competitors. 
  • So I am going to pay $10 million, I am going to make $10 million so the growth has zero value.   
3.  Profitable Growth Occurs Only Within a Franchise 
  • The only case where growth has value is where the growth occurs behind the protection of an identifiable competitive advantage. 
  • Growth only has value where there are sustainable competitive advantages. 
  • And in that case, usually, what barriers to entry means is there are barriers to companies stealing market share from each other.
  • There is usually stable market share which is symptomatic of that last situation that means in the long run, the company will grow at the industry rate
  • And in the long run, almost all industries grow at the rate of global GDP.   

So in these three situations, the growth only matters in the last one where its profitable (growing within a franchise) is.
  • And the critical issue in valuation is either management or the G&D approach will tell you the extent to which that is important or you have a good reliable valuation and there is no value to the growth because there are no barriers to entry. 
  • Or it is down here (growth is profitable) and there obviously you want to get the growth for free.
  • You could pay a full earnings power value and get a decent return. (Buffett with Coke-Cola in 1988).  

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at                           
studying/teaching/investing Page 27

Notes from video lecture by Prof Bruce Greenwald

Wednesday, 8 October 2014

You are a lot better estimating the Cost of Capital without using fancy formulas

Estimate the Cost of Capital 
You have to estimate the cost of capital.  

First of all, the cost of equity will always be above the cost of the debt.  Secondly, the most expensive cost of equity is the type that venture capitalists have to pay.  If you read the VC magazines, they will tell you what returns they have to show on their old funds to raise money on their new funds.  These days that number is 15%.  Without doing any betas, you know the cost of equity is between 7% and 15% which is a lot better than the beta estimates.  

  • Usually for the low risk firm with not a lot of debt, the cost of capital will be about 7% to 8%. 
  • For a medium risk firm these days with reasonable debt, it will be about 9% to 10%.  
  • For high risk firms, it will be 11% to 13%.

You are a lot better doing that than trying to estimate using fancy formulas.  So you get a cost of capital.

And the nice thing about not including the growth is that errors in the cost of capital are typically not that big. If you are 1% off in the WACC, you are 10% error in the valuation and that is not a killer error in valuation. 

Notes from video lecture by Prof Bruce Greenwald
Cue:  7/11

Value Investing Process by Prof Bruce Greenwald

Greenwald Value Investing Class on February 12, 2008 

Retail stocks are in the tank so investors may be unreflectively selling. You will find many low market to book stocks.  You will find growing companies being dumped indiscriminately. But remember at the end of the day why are you applying this type of search strategy?   Because when you think this stock is a bargain you have to be able to explain why you are the only one who spotted that opportunity.  You have to have some rational for why the opportunity exists. 

You start with sensible search

Then value the stock: basically look at three basic elements of value: 
1. Asset Value
2. Earnings Power Value
3. Franchise Value   

Value Investing Process
SEARCH:  Obscure, distressed, Poor performance, small
VALUATION: Asset Value, Earnings Power Value
REVIEW: key issues, collateral evidence, personal biases
MANAGE RISK:  Margin of Safety, patience, You

Anybody does a DCF, I just throw it out.  Unless it is associated with a short term liquidation.

We spoke about asset values (AVs) and earnings power value (EPV). Earnings, if they are sustainable, are supported either by assets or by barriers to entry. If you had a company with a lot of earnings but no assets what sooner or later will happen to profits if there are no barrier to entry in this market?   They will be competed away.  I can do that for no assets.  No net assets, no barriers to entry and then no protection, no value.

The value of Growth is the least reliable element of value.  
You have to be able to forecast what is going to happen to growth.  It is not just looking there now and applying a value to it, you have to forecast what the changes are going to be. When you look at these things when you have done them yourself, if you look at terminal values for growing companies, you ought to have an immediate sense that it is highly sensitive to the assumptions.  And that is not comforting to a value investor who wants to have an immediate sense of what they are buying with a reasonable amount of certainty.

Notes from video lecture by Prof Bruce Greenwald

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.