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.

http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Why Value Investing works. Buying cheaply works.

WHY VALUE INVESTING 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.

http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

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)

----------


1.  SEARCH STRATEGY

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.


2. VALUATION STRATEGY

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?


3. PATIENCE

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.

The BAD NEWS:

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
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

OPPORTUNITIES IN VALUE INVESTING

OPPORTUNITIES IN VALUE INVESTING

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 Aldridge56@aol.com studying/teaching/investing Page 7

Where do you always want to start a valuation?

STARTING 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.  

Illustration

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 Aldridge56@aol.com                           
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 Aldridge56@aol.com                           
studying/teaching/investing Page 26

 Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf



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

http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

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

Summary 
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.

Growth 
 

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 Aldridge56@aol.com                           
studying/teaching/investing Page 27

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

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
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

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.            

 

 

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

     

 

Calculating investment returns from growth stocks - returns from dividends and share buybacks, returns from retained earnings (reinvestment by the company) and returns from organic growth.

The calculation in the short run is not that hard to do.

1.  First you have to know where the money is going.

• Is WMT expanding in Mexico or is WMT expanding somewhere in Europe where it has no competitive advantages. 
• You can look at the simple economics with and without infrastructure costs and you see the returns if they have to build the infrastructure are about 7% to 8% which is below their cost of capital (Kcost). 
• If they can add stores to an existing infrastructure (stores near existing supply depots and other WMT stores), then the returns are more like 17% to 20%.
• But you ought to know enough about the economics of growth stocks, so you know those numbers. 

2.  You know what the reinvestment return is. 

• If the return is 20% after tax and their cost is 10%, what each dollar they reinvest worth?   $2 because they are earning 2x the cost of capital.  
• So what you are going to do is take that reinvestment return—that 5% that is reinvested and multiply it by the difference between the capital return and cost of capital.
• If they are earning 7% and Kcost is 10%, they are destroying at the rate of 3%.

3.  Is reinvesting in cash a good idea—no.

• A crappy return. 
• The longer they hold that cash the lower the return is in terms of reinvestment.   
• You are losing the return on that cash. 

So you look at the earnings return, what you get in cash, the fraction that is distributed either through buy backs and dividends and the fraction that is reinvestment and the value creation characteristics of the reinvestment.    

 

4.  Then certain companies get returns essentially without much investment--which is that if you own a franchise, even without conscious expansion, that franchise will sometimes grow.   The incremental investment involved is negligible. 

• When WMT sees an increase in SSS, it typically doesn’t have to build any new stores. 
• Especially if it is a price increase, its doesn’t have to add new people or add SKUs.
• What is the capital investment required for that increase in sales?  Only inventory.
• If their inventory turns are 8 times, then for every $1 of sales, they make about 7.5 cents in profit.
• That organic growth generates returns of about 16%. 
• They are higher than that in reinvestment because typically they will refinance two-thirds of the inventory investment with debt.
• So you will be getting returns of 150% on the capital you invest to support that organic growth. 

Why don’t returns get bid away by entrants whose store economics have improved?  That is where the existence of a franchise is crucial. If there were no barriers to entry, then gains would be get competed away by additional competitors.  So it is only growth behind those barriers that creates value.  

 

5.   You want to look next—you have your cash return, your investment return and then the return from organic growth and compare that to the return of the market to get a feel for your margin of safety is in terms of returns–then you want to see what will change that picture in a sustainable way.

 

 

Recap: 
Verify the existence of a franchise

Cash earnings return is 1/P/E.

Identify Cash distribution in terms of dividends and buybacks

Identify organic (low investment growth)

Identify investment return-multiple a percent of retained earnings

Compare to the market representing D/P & growth rate.

Identify options positive and negative.


Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Growth creates value only when the company has a competitive advantage. If there were no barriers to entry, then gains would be get competed away by additional competitors.

Why don’t returns get bid away by entrants whose store economics have improved? 

• That is where the existence of a franchise is crucial.
• If there were no barriers to entry, then gains would be get competed away by additional competitors. 
• So it is only growth behind those barriers that creates value.  

When you look at growth, this is what you look at: 
1.  First is verify the franchise.  If you don’t have a franchise, then growth is worth $0.

• Look at historical returns, share stability. 
• Look for sustainable competitive advantages. 

2.  Then calculate a return. 

• You don’t look at a P/E ratio, you look at an earnings ratio.
• If you are paying 14x earnings, it is a 7% if that P/E ratio stays the same and the earnings stay the same. You pay 11 times, it is 9%. 8 times, then 12.5%.  

3.   Out of that return there are two things that can happen to you—the first is that give it to you in your hot little hand in cash. What are you getting in cash?

• If it is a 8 times multiple, it is a 12.5% return.   
• The dividend is 2.5% and you are buying back 5% in stock per year, you are getting 7.5% in your hot little hand.
• If dividends and buyback policies are stable, then what are you getting.
• There are not stable then you have to estimate what they will be over time.  
• But you want to know what fraction of the earnings get distributed.
• So if 11 times multiple and they historically distribute a third of the earnings, 1/11 is a 9% and 1/3 of that is a 3% distribution. 

4.  What happens to the other 6%?  

• That gets reinvested—there the critical thing about the value is how effective do they reinvest that money?
• So in growth stocks, capital allocation is critical.
• Because (mgt.) is typically keeping most of your money and you care about how effectively they are investing it.      

5.  You want to look next—you have your cash return (3), your investment return (4) and then the return from organic growth.

 

6.  Compare that to the return of the market to get a feel for your margin of safety is in terms of returns–then you want to see what will change that picture in a sustainable way.  

 

 

Recap:  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?

 

 

 

Explanatory notes:

 

Dividends, buybacks & reinvestment of retained earnings:  So you look at the earnings return, what you get in cash, the fraction that is distributed either through buy backs and dividends and the fraction that is reinvestment and the value creation characteristics of the reinvestment.     

Organic growth:  Then certain companies get returns essentially without much investment--which is that if you own a franchise, even without conscious expansion, that franchise will sometimes grow.   The incremental investment involved is negligible.

 

 

 

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Value Investing in Practice

Value Investing in Practice Long-term - Fundamental (look at underlying business) (1) Lookintelligentlyforvalueopportunities(LowP/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) Knowwhatyouknow   Not all value is measurable   Not all value is measurable by YOU (Circle of Competence) (3) Youdon'thavetoswing 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) There are three parts to being effective:

http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Greenwald Lecture at Gabelli Value Investing Conference

Published on 16 Jun 2014

Professor Bruce Greenwald lecture at Gabelli Value Investing Conference at Princess Gate, London in 2005. He looks at the art of value investing and investment processes.

Bruce Greenwald Interview (Full Version)

The most succinct description of value investing

"The value investor seeks to purchase a security at a bargain price, the proverbial dollar for 50 cents." 

Of course, there is considerably more to it than that.   However, this is a good starting point.



History of the Teaching of Value Investing in Columbia University

1928:  Benjamin Graham began to teach a course on security analysis at Columbia University.

1978:  Roger Murray, an author of the fifth edition of Security Analysis retired, and the course and the tradition disappeared from the formal academic curriculum.

1992:  Mario Gabelli, who had taken the course with Roger Murray, prevailed on Murray to offer a series of lectures on value investing to Gabelli's own analysts, who had found nothing like this in their formal MBA courses.  Bruce Greenwald, the newly appointed Heilbrunn Professor of Asset Management and Finance, attended those lectures out of curiosity.

1993:  Bruce Greenwald dragooned Roger Murray into joining him in offering a revived and revised version of the value course in Columbia University.

Bruce Greenwald on Value Investing

Do not miss his comments @ 9 minutes on Buffett's buying of Washington Post in Summer of 1972.  The share price of Washington Post dropped 45% after he bought; and it was still a great investment.

If you behave the way such as Graham and Dodds prescribe, there are no bad days in the market.  When the market is down, you got bargains and it is lovely to think of what you are buying at low prices. When the market is up, the bargains are gone, but you are rich.