Showing posts with label value investing. Show all posts
Showing posts with label value investing. Show all posts
Sunday 17 January 2016
Saturday 16 January 2016
Philip Fisher and Walter Schloss
A Dozen Things I’ve Learned from Philip Fisher and Walter Schloss About Investing
1. “I had made what I believe was one of the more valuable decisions of my business life. This was to confine all efforts solely to making major gains in the long-run…. There are two fundamental approaches to investment. There’s the approach Ben Graham pioneered, which is to find something intrinsically so cheap that there is little chance of it having a big decline. He’s got financial safeguards to that. It isn’t going to go down much, and sooner or later value will come into it. Then there is my approach, which is to find something so good–if you don’t pay too much for it–that it will have very, very large growth. The advantage is that a bigger percentage of my stocks is apt to perform in a smaller period of time–although it has taken several years for some of these to even start, and you’re bound to make some mistakes at it. [But] when a stock is really unusual, it makes the bulk of its moves in a relatively short period of time.” Phil Fisher understood (1) trying to predict the direction of a market or stock in the short-term is not a game where one can have an advantage versus the house (especially after fees); and (2) his approach was different from Ben Graham.
2. “I don’t want a lot of good investments; I want a few outstanding ones…. I believe that the greatest long-range investment profits are never obtained by investing in marginal companies.” Warren Buffett once said: “I’m 15% Fisher and 85% Benjamin Graham.” Warren Buffett is much more like Fisher in 2013 than the 15% he once specified, but only he knows how much. It was the influence of Charlie Munger which moved Buffet away from a Benjamin Graham approach and their investment in See’s Candy was an early example in which Berkshire paid up for a “quality” company. Part of the reason this shift happened is that the sorts of companies that Benjamin Graham liked no longer existed the further way the time period was from the depression.
3. “The wise investor can profit if he can think independently of the crowd and reach the rich answer when the majority of financial opinion is leaning the other way. This matter of training oneself not to go with the crowd but to be able to zig when the crowd zags, in my opinion, is one of the most important fundamentals of investment success.” The inevitable math is that you can’t beat the crowd if you are the crowd, especially after fees are deducted.
4. “Usually a very long list of securities is not a sign of the brilliant investor, but of one who is unsure of himself. … Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others which they know nothing about.” For the “know-something” active investor like Phil Fisher, wide diversification is a form of closet indexing. A “know-something” active investor must focus on a relatively small number of stocks if he or she expects to outperform a market. By contrast, “know-nothing” investors (i.e., muppets) should buy a low fee index fund.
5. “If the job has been correctly done when a common stock is purchased, the time to sell it is almost never.” Phil Fisher preferred a holding period of almost forever (e.g., Fisher bought Motorola in 1955 and held it until 2004). The word “almost” is important since every company is in danger of losing its moat.
6. “Great stocks are extremely hard to find. If they weren’t, then everyone would own them. The record is crystal clear that fortune – producing growth stocks can be found. However, they cannot be found without hard work and they cannot be found every day.” Fisher believed that the “fat pitch” investment opportunity is delivered rarely and only to those investors who are willing to patiently work to find them.
7. “Focus on buying these companies when they are out of favor, that is when, either because of general market conditions or because the financial community at the moment has misconceptions of its true worth, the stock is selling at prices well under what it will be when it’s true merit is better understood.” Like Howard Marks, Fisher believed that (1) business cycles and (2) changes in Mr. Market’s attitude are inevitable. By focusing on the value of individual stocks (rather than just price) the investor can best profit from these inevitable swings.
8. “The successful investor is usually an individual who is inherently interested in business problems.” A stock is a part ownership of a business. If you do not understand the business you do not understand that stock. If you do not understand the business you are investing in you are a speculator, not an investor.
9. “The stock market is filled with individuals who know the price of everything, but the value of nothing.” Price is what you pay and value is what you get. By focusing on value Fisher was able to outperform as an investor even though he did not look for cigar butts.
10. “It is not the profit margins of the past but those of the future that are basically important to the investor.” Too often people believe that the best prediction about the future is that it is an extension of the recent past.
11. “There is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us. None of us likes to admit to himself that he has been wrong. If we have made a mistake in buying a stock but can sell the stock at a small profit, we have somehow lost any sense of having been foolish. On the other hand, if we sell at a small loss we are quite unhappy about the whole matter. This reaction, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process. More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous.” Fisher was very aware of the problems that loss aversion bias can cause.
12. “Conservative investors sleep well.” If you are having trouble sleeping due to worrying about your portfolio, reducing risk is wise. Life is too short to not sleep well, but also fear can result in mistakes.
Walter Schloss
1. “I think investing is an art, and we tried to be as logical and unemotional as possible. Because we understood that investors are usually affected by the market, we could take advantage of the market by being rational. As [Benjamin] Graham said, ‘The market is there to serve you, not to guide you!’.” Walter Schloss was the closest possible match to the investing style of Benjamin Graham. No one else more closely followed the “cigar butt” style of investing of Benjamin Graham. In other words, if being like Benjamin Graham was a game of golf, Walter Schloss was “closest to the pin.” He was a man of his times and those times included the depression which had a profound impact on him. While his exact style of investing is not possible today, today’s investor’s still can learn from Walter Schloss. It is by combining the best of investors like Phil Fisher and Walter Schloss and matching it to their unique skills and personality that investors will find the best results. Warren Buffet once wrote in a letter: “Walter outperforms managers who work in temples filled with paintings, staff and computers… by rummaging among the cigar butts on the floor of capitalism.” When Walter’s son told him no such cigar butt companies existed any longer Walter told his son it was time to close the firm. The other focus of Walter Schloos was low fees and costs. When it came to keeping overhead and investing expenses low, Walter Schloss was a zealot.
2. “I try to establish the value of the company. Remember that a share of stock represents a part of a business and is not just a piece of paper. … Price is the most important factor to use in relation to value…. I believe stocks should be evaluated based on intrinsic worth, NOT on whether they are under or over priced in relationship with each other…. The key to the purchase of an undervalued stock is its price COMPARED to its intrinsic worth.”
3.”I like Ben’s analogy that one should buy stocks the way you buy groceries not the way you buy perfume… keep it simple and try not to use higher mathematics in you analysis.”Keeping emotion out of the picture was a key part of the Schloss style. Like Ben Graham he as first and foremost rational.
4. “If a stock is cheap, I start buying. I never put a stop loss on my holdings because if I like a stock in the first place, I like it more if it goes down. Somehow I find it difficult to buy a stock that has gone up.”
5. “I don’t like stress and prefer to avoid it, I never focus too much on market news and economic data. They always worry investors!” Like all great investors in this series, the focus of Schloss was on individual companies not the macro economy. Simpler systems are orders of magnitude easier to understand for an investor.
6. “The key to successful investing is to relate value to price today.” Not only did Schloss not try to forecast the macro market, he did not really focus forecasting the future prospects of the company. This was very different than the Phil Fisher approach which was focused on future earnings.
7. “I like the idea of owning a number of stocks. Warren Buffet is happy owning a few stocks, and he is right if he is Warren….” Schloss was a value investor who also practiced diversification. Because of his focus on obscure companies and the period in which he was investing, Walter was able to avoid closet indexing.
8. “We don’t own stocks that we’d never sell. I guess we are a kind of store that buys goods for inventory (stocks) and we’d like to sell them at a profit within 4 years if possible.” This is very different from a Phil Fisher approach where his favorite holding period is almost forever. Schloss once said in a Colombia Business school talk that he owned “some 60-75 stocks”.
9. “Remember the word compounding. For example, if you can make 12% a year and reinvest the money back, you will double your money in 6 years, taxes excluded. Remember the rule of 72. Your rate of return into 72 will tell you the number of years to double your money.” Schloss felt that “compounding could offset [any advantage created by] the fellow who was running around visiting managements.”
10. “The ability to think clearly in the investment field without the emotions that are attached to it is not an easy undertaking. Fear and greed tend to affect one’s judgment.” Schloss was very self-aware and matched his investment style to his personality. He said once” We try to do what is comfortable for us.”
11. “Don’t buy on tips or for a quick move.”
12. “In thinking about how one should invest, it is important to look at you strengths and weaknesses. …I’m not very good at judging people. So I found that it was much better to look at the figures rather than people.” Schloss knew that Warren Buffett was a better judge of people than he was so Walter’s approach was almost completely quantitative. Schloss knew to stay within his “circle of competence”. Schloss said once: “Ben Graham didn’t visit management because he thought figure told the story.”
http://25iq.com/2013/10/27/a-dozen-things-ive-learned-from-philip-fisher-and-walter-schloss-about-investing/
Thursday 26 November 2015
Donald Yacktman: "Viewing Stocks as Bonds"
Investment Philosophy
- Good businesses that dominate their industry
- Shareholder-oriented management
- Low purchase price
A good business may contain one or more of the following:
- High market share in principal product and/or service lines
- High cash return on tangible assets
- Relatively low capital requirements allowing a business to generate cash while growing
- Short customer repurchase cycles and long product cycles
- Unique franchise characteristics
High Cyclicality Low Cyclicality
Low Capital Intensity Media Consumer Staples
High Capital Intensity Capital Goods Utilities
Secular growth, not cyclical growth preferred.
Published on 30 Jul 2015
Drawing on his four decades of experience, Don Yacktman identifies the three key characteristics of value stocks. In this talk, he shares his investment philosophy along with the lessons he has learned from the markets and from life.
About the speaker:
Don Yacktman is Partner and Portfolio Manager of Yacktman Asset Management. He began his career at Yacktman founding the company as its President, Portfolio Manager, and Chief Investment Officer. Since founding the company Don has been awarded the 1994 “Portfolio Manager of the Year” by Mutual Fund Letter. Don has also been nominated by Morningstar as Fund Manager of the Decade in 2009, and finalist for Morningstar’s Domestic-Stock Manager of the Year award in 2011, and “Portfolio Manager of the Year” in 1991. Don holds an MBA with distinction from Harvard University.
Sunday 22 November 2015
8 Rules for Picking Perfect Value Stocks
Tim Melvin's 8 Rules
1. Book value matters
2. Buy maximum pessimism
3. Do not do what everyone else is doing
4. Margin of safety is critical
5. Scale into stocks (Double down at liquidation value)
6. React; don't predict
7. Patience is Profitable
8. Do not play just because the casino is open
Tuesday 10 November 2015
Rapid growth can lead to big returns .... or painful mistakes. Be knowledgeable.
Growth is a strategy in which stock pickers may have a better chance of success.
Buying growth with a broad-brushed index approach is a formula for underperformance, but some smart choices can lead to outperformance.
Value companies
A good value investment will rise in price because the market will eventually take notice of it - either because people become more widely aware of its performance or because they recognise that its problems are being corrected.
As the market corrects its earlier impressions, the stock rises, sometimes dramatically.
If it is to continue to rise, however, the company has to do more than show it is worthy of recognition. It has to perform ... and grow.
Some "value" investments actually have great growth potential, while many will at best turn in tepid growth even if all goes well.
Growth companies
The best growth companies, however, will achieve phenomenal expansion.
And the very best can keep it up for years, letting you grow wealth while deferring taxes.
That kind of long-term, high growth is what creates 20-baggers an even 100-baggers.
A single investment like that can transform your portfolio - your whole financial future, in fact.
And you are unlikely to find such a company without identifying extraordinary growth potential.
These businesses aren't just looking to succeed in an established industry. They want to shake things up.
Two Catches
1. Rapid growth usually doesn't last long.
Some companies mange to grow sales at an exponential rate (over 100%) for a year, maybe even several. But maintaining that pace eventually becomes impossible.
If they are successful, companies naturally mature to a state of slow growth.
They evolve into the kind of large, steady companies that offer steady, but usually not large, returns.
Using a growth strategy means finding companies that can sustain extraordinary growth longer than the market realises and expects, either because you have caught it early in its growth cycle, or because it has such strong structural advantages that it maintains a dominant position in its industry.
2. The market tries to anticipate the future.
You may have heard about companies being "priced" for future events, including an expectation that future earnings will be a lot better than the ones you see today.
Sometimes predictions are too rosy; sometimes they underestimate what a company can do.
When they are too optimistic, high-priced stocks crash down to earth.
When they are too cautious, an "expensive" stock can keep rising sometimes for years.
We want to find the latter.
Comments:
If you own equal amount of ten stocks and one drops 50%, your portfolio goes down 5%.
If you own equal amount of ten stocks and one goes up 500%, your whole portfolio increases in value by 50%. From just ONE stock.
You can apply that logic on whatever scale you like - a concentrated portfolio of just a few stocks or a less-volatile portfolio of 100 stocks.
With diligence, patience and the right approach, you will find stocks that go up 500% or more.
Of course, you will also pick some that go down 90%.
But is it not true that value stocks beat growth stocks? Yes, they do ... broadly speaking. Unless, that is, you pick the right growth companies.
These rapid growth companies are a part of your broader approach to wealth creation.
Buying growth with a broad-brushed index approach is a formula for underperformance, but some smart choices can lead to outperformance.
Value companies
A good value investment will rise in price because the market will eventually take notice of it - either because people become more widely aware of its performance or because they recognise that its problems are being corrected.
As the market corrects its earlier impressions, the stock rises, sometimes dramatically.
If it is to continue to rise, however, the company has to do more than show it is worthy of recognition. It has to perform ... and grow.
Some "value" investments actually have great growth potential, while many will at best turn in tepid growth even if all goes well.
Growth companies
The best growth companies, however, will achieve phenomenal expansion.
And the very best can keep it up for years, letting you grow wealth while deferring taxes.
That kind of long-term, high growth is what creates 20-baggers an even 100-baggers.
A single investment like that can transform your portfolio - your whole financial future, in fact.
And you are unlikely to find such a company without identifying extraordinary growth potential.
These businesses aren't just looking to succeed in an established industry. They want to shake things up.
Two Catches
1. Rapid growth usually doesn't last long.
Some companies mange to grow sales at an exponential rate (over 100%) for a year, maybe even several. But maintaining that pace eventually becomes impossible.
If they are successful, companies naturally mature to a state of slow growth.
They evolve into the kind of large, steady companies that offer steady, but usually not large, returns.
Using a growth strategy means finding companies that can sustain extraordinary growth longer than the market realises and expects, either because you have caught it early in its growth cycle, or because it has such strong structural advantages that it maintains a dominant position in its industry.
2. The market tries to anticipate the future.
You may have heard about companies being "priced" for future events, including an expectation that future earnings will be a lot better than the ones you see today.
Sometimes predictions are too rosy; sometimes they underestimate what a company can do.
When they are too optimistic, high-priced stocks crash down to earth.
When they are too cautious, an "expensive" stock can keep rising sometimes for years.
We want to find the latter.
Comments:
If you own equal amount of ten stocks and one drops 50%, your portfolio goes down 5%.
If you own equal amount of ten stocks and one goes up 500%, your whole portfolio increases in value by 50%. From just ONE stock.
You can apply that logic on whatever scale you like - a concentrated portfolio of just a few stocks or a less-volatile portfolio of 100 stocks.
With diligence, patience and the right approach, you will find stocks that go up 500% or more.
Of course, you will also pick some that go down 90%.
But is it not true that value stocks beat growth stocks? Yes, they do ... broadly speaking. Unless, that is, you pick the right growth companies.
These rapid growth companies are a part of your broader approach to wealth creation.
Thursday 22 October 2015
Growing versus Non-growing company. Value Investing versus Growth Investing.
A growing company versus a non-growing company
Given the choice, you should choose to invest in a company that is growing its revenues, earnings, and free cash flows over time. This company continues to grow its intrinsic value and over time, you will be well rewarded for investing in it.
Is investing into growing companies the same as growth investing?
Let us illustrate using company Y. Company Y is a company that is growing its revenues, and earnings 15% per year, consistently and predictably for the last 10 years.
At certain times, Company Y is available at a P/E of 10. Buying Company Y at this stage is a bargain. It is available at a bargain price. This is value investing. If you use PEG ratio of Peter Lynch, it is available at a PEG ratio of 10/15 which is < 1.
At other times, Company Y is available at a P/E of 20. Buying Company Y at this stage is not value investing. Those who buy at this P/E may feel they are also buying a bargain, as they projected that the earnings of Company Y is going to be great and the growth in earnings higher than the 15% per annum in the past. Maybe they projected that the earnings will be growing 30% per year. This is growth investing. If you use PEG ratio of Peter Lynch, it is still available at a PEG ratio of < 1 (= 20/30).
Thus, is there a difference between value investing and growth investing, from a bargain perspective? There appear to be 2 sides of the same coin. Those buying into the stock using these strategies are of the opinion they are buying a bargain.
However, there are differences too. Historically, value investing has outperformed growth investing when assessed over a long time frame of investing. But beware of such analysis. Among the value investing stocks selection, many of the companies did not perform as expected and the fundamentals tanked. Likewise, those stocks in growth investing, projected to grow at high rate and bought at high P/E, failed to deliver the growth and did not perform as expected.
Let us learn from Buffett. Stays with the company that you understand. This company must have business with durable competitive advantage. Its management must have unquestionable integrity. Finally, buy them at a fair price.
Yes, search out for the growing companies. I too love such companies. Above all, emphasizes the quality of the growth of business and its management. Finally, look at the price (valuation). Whether it is value or growth investing, buy growing companies at reasonable price (GARP).
Given the choice, you should choose to invest in a company that is growing its revenues, earnings, and free cash flows over time. This company continues to grow its intrinsic value and over time, you will be well rewarded for investing in it.
Is investing into growing companies the same as growth investing?
Let us illustrate using company Y. Company Y is a company that is growing its revenues, and earnings 15% per year, consistently and predictably for the last 10 years.
At certain times, Company Y is available at a P/E of 10. Buying Company Y at this stage is a bargain. It is available at a bargain price. This is value investing. If you use PEG ratio of Peter Lynch, it is available at a PEG ratio of 10/15 which is < 1.
At other times, Company Y is available at a P/E of 20. Buying Company Y at this stage is not value investing. Those who buy at this P/E may feel they are also buying a bargain, as they projected that the earnings of Company Y is going to be great and the growth in earnings higher than the 15% per annum in the past. Maybe they projected that the earnings will be growing 30% per year. This is growth investing. If you use PEG ratio of Peter Lynch, it is still available at a PEG ratio of < 1 (= 20/30).
Thus, is there a difference between value investing and growth investing, from a bargain perspective? There appear to be 2 sides of the same coin. Those buying into the stock using these strategies are of the opinion they are buying a bargain.
However, there are differences too. Historically, value investing has outperformed growth investing when assessed over a long time frame of investing. But beware of such analysis. Among the value investing stocks selection, many of the companies did not perform as expected and the fundamentals tanked. Likewise, those stocks in growth investing, projected to grow at high rate and bought at high P/E, failed to deliver the growth and did not perform as expected.
Let us learn from Buffett. Stays with the company that you understand. This company must have business with durable competitive advantage. Its management must have unquestionable integrity. Finally, buy them at a fair price.
Yes, search out for the growing companies. I too love such companies. Above all, emphasizes the quality of the growth of business and its management. Finally, look at the price (valuation). Whether it is value or growth investing, buy growing companies at reasonable price (GARP).
Friday 26 June 2015
The Perfect Moment to Buy a Stock
Hi,
I hope you've been enjoying my newsletter so far!
You've been a subscriber for about a month now, so I would like to take this moment to really thank you for your support! I truly appreciate it, and I'm hoping I can continue to provide you with some excellent content that you can't get anywhere else, and keep you as a loyal subscriber for even longer.
Today I will share with you how to identify the perfect moment to buy a stock, and it's probably different from what you expect. Why? Because it has little to do with timing, and more to do with the stock price in relation to the intrinsic value of a company. Let me explain.
"Price is what you pay, value is what you get."
There is a crucial difference between price and value, and the above quote by Warren Buffett captures this perfectly. If you want to sell your desk chair on eBay, you can ask any price for it you like. However, the value the buyer receives in return, a desk chair, remains exactly the same, regardless of the price you decide to ask.
It's the same with stocks. A stock price says little about how much a stock, which is essentially a tiny slice of a business, is actually worth. Investors can ask any price they like, but this doesn't change the underlying business. This means it is possible for stock prices to deviate significantly from their intrinsic value, which is great, because exploiting mispriced stocks is what value investing is all about!
So what is the perfect time to buy a stock?
Well, you first have to determine whether you are dealing with a financially healthy company. Secondly, using conservative inputs, you need to estimate the intrinsic value of a company to determine what a stock should realistically be worth. Is the stock trading at a price way below the intrinsic value you calculated? Sweet! Then this is the perfect time to buy. If not, put it on your watch list until it is finally cheap enough to get in.
Timing the market, or trying to predict when a stock will move up or down in the short run, is impossible. You might get lucky a few times, but this strategy is doomed to fail in the long run, since prices can be extremely volatile, highly irrational and therefore 100% unpredictable. The only sound way to determine when to buy is to look at the stock price in relation to the intrinsic value of the underlying company.
Don't worry if the price declines further after your initial investment, because now you can buy more of a wonderful company at an even lower price! You don't have to buy at the absolute bottom. You just have to buy it for a cheap enough price to make a more than handsome return.
Now that you know when to buy a stock, you might be interested in learning when to sell. In episode #18 of my value investing podcast I cover the only three reasons to ever sell a stock. Here is a link for you below:
https://www.valuespreadsheet.com/investing-podcasts
Cheers, and all the best to you!
Nick
Saturday 18 April 2015
Want to invest like Warren Buffett?
It's about quality investing
Ask Buffett, who he thinks is the greatest investor in the world, and he will probably tell you his teacher: Benjamin Graham.
Having studied economics at Columbia Business School, Warren Buffett was taught by Benjamin Graham, and if that was not enough of a head start in his investment career, Buffett was fortunate enough to work with Graham, too. Both are seen as value investors – buying companies that trade less than their intrinsic values.
However, there is a school of thought that sees value as a bit of a misnomer. Clyde Rossouw, manager of the Investec Global Franchise Fund, argues that while Graham is known as the father of value investing, in truth he should probably be known as the father of quality investing, as most of the characteristics he speaks about in terms of the companies he looks for references 'quality' attributes, rather than value.
Value investing by definition involves buying bargains.
However, given the choice between buying a good-quality company rated on a higher price, or a lower-quality company attractively priced, Buffett, like Graham will opt for the former.
That's because investors are more inclined to pay up for quality companies. In turn this offers potential for the share prices of good-quality companies to recover to (and above) their long-term average earnings multiple.
That's because investors are more inclined to pay up for quality companies. In turn this offers potential for the share prices of good-quality companies to recover to (and above) their long-term average earnings multiple.
The "challenge" of too much cash
Besides gearing up for 'Investor Woodstock', what is the Sage of Omaha doing now? Sitting on a lot of cash – according to media reports Berkshire currently has around $25 billion in excess cash.
This 'challenge' of too much cash, some argue, is changing Buffett's investment approach.
Rossouw points to Buffett's investment in Burlington Northern Santa Fe Railroad operator, as an example of the investor trying to shed some of this cash. 'Yes, this investment has a strong 'moat' but it is highly capital intensive – keeping a railway maintained requires you to spend a lot of money consistently over time. It helps Buffett deal with a key problem which is the largess of excess cash generated by his insurance businesses each year.'
Rossouw points to Buffett's investment in Burlington Northern Santa Fe Railroad operator, as an example of the investor trying to shed some of this cash. 'Yes, this investment has a strong 'moat' but it is highly capital intensive – keeping a railway maintained requires you to spend a lot of money consistently over time. It helps Buffett deal with a key problem which is the largess of excess cash generated by his insurance businesses each year.'
Buffett's cash pile could mean many things.
- It could be, as some believe, a problem of too much money, and not enough investment opportunities.
- It could be a precautionary measure to make sure his company is well positioned to cope in an increasingly uncertain environment.
- It could be that Buffett is positioning himself to make another big deal.
Or it could be all of the above. But then we can't know everything about the most glorified and respected investor of our time.
Read more: http://www.thisismoney.co.uk/money/diyinvesting/article-2957271/Four-things-not-know-Warren-Buffett-probably-should.html#ixzz3XeBaAw4y
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.
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.
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:
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.
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
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
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.
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.
Not all values are measurable (as in the Microsoft case.)
3. Search for Opportunities
The third idea is that you look Intelligently for opportunities.
The bad news is that any professional investor knows--they run up the score whether you swing or not.
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
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 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.
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.
For the EPV, you basically have to calculate two things:
If the picture looks like case A (AV > EPV), what is going on assuming, you have done the right valuation here?
Notes from video lecture by Prof Bruce Greenwald
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.
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.
- 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.
- 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.
Summary
Now to summarize about growth:
1. Suppose I invest that $100 million at a competitive disadvantage.
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 in these three situations, the growth only matters in the last one where its profitable (growing within a franchise) is.
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
Now to summarize about growth:
- growth at a competitive disadvantage destroys value,
- growth on a level playing field neither creates nor destroys value, and
- 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.
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.
- So I am going to pay $10 million, I am going to make $10 million so the growth has zero value.
- 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
Wednesday 8 October 2014
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
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.
- 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).
- 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.
- 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
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf
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