Glossary (7)

 Glossary

Tax-loss selling—selling just prior to year-end to realize losses for tax purposes 

Technical analysis—analysis of past security-price fluctuations using charts 

Tender offer—a cash bid to buy some or all of the securities of a target company 

Thrift conversion—the conversion of a mutual thrift institution to stock ownership 

Top-down investing—strategy involving making a macroeconomic forecast and then applying it to choose individual investments 

Torpedo stocks—stocks for which investors have high expectations and which are therefore vulnerable to substantial price declines 

Trader—a person whose job it is to buy and sell securities, earning a spread or commission for bringing buyers and sellers together 

Trading flat—available for sale or purchase without payment for accrued interest 

Treasury bills (T-bills)—noninterest-bearing obligations of the U.S. government, issued on a discount basis with original maturities ranging from three months to one year; the interest income from Treasury bills is the difference between the purchase price and par 

Treasury bonds (T-bonds) —U.S. government obligations with original maturities of ten years or more; interest is paid semiannually 

Treasury notes (T-notes) —U.S. government obligations with original maturities ranging from one to ten years; interest is paid semiannually 

Value - the worth, calculated through fundamental analysis, of an asset, business, or security 

Value investing—a risk-averse investment approach designed to buy securities at a discount from underlying value 

Value investment—undervalued security; a bargain 

Volume—the number of shares traded 

Window dressing—the practice of making a portfolio look good for quarterly reporting purposes 

Working capital—current assets minus current liabilities 

Writing call options—selling call options on securities owned 

Yield —return calculated over a specific period

 Zero-coupon bond—a bond that accrues interest until maturity rather than paying it in cash 

Glossary (6)

  Glossary

Puttable bond—bond with embedded put features allowing holders to sell the bonds back to the issuer at a specified price and time (see callable bond) 

Recapitalization—financial restructuring of a company whereby the company borrows against its assets and distributes the proceeds to shareholders 

Relative-performance orientation—the tendency to evaluate investment results by comparing one’s investment performance with that of the market as a whole 

Return—potential gain 

Rights offering—a financing technique whereby a company issues to its shareholders the preemptive right to purchase new stock (or bonds) in the company or occasionally in a subsidiary company 

Risk—amount and probability of potential loss 

Risk arbitrage—a specialized area involving investment in far-from-risk-free takeovers as well as spinoffs, liquidations, and other extraordinary corporate transactions 

Secured debt—debt backed by a security interest in specific assets 

Security—a marketable piece of paper representing the fractional ownership of a business or loan to a business or government entity 

Self-tender—an offer by a company to repurchase its own securities 

Senior-debt security—security with the highest priority in the hierarchy of a company’s capital structure 

Sensitivity analysis—a method of ascertaining the sensitivity of business value to small changes in the assumptions made by investors 

Share buybacks—corporate stock repurchases 

Shareholder’s (owner’s) equity—the residual after liabilities are subtracted from assets 

Short-selling—the sale of a borrowed security (see going long) 

Short-term relative-performance derby—manifestation of the tendency by institutional investors to measure investment results, not against an absolute standard, but against broad stock market indices resulting in an often speculative orientation 

Sinking fund—obligation of a company to periodically retire part of a bond issue prior to maturity 

Speculation—an asset having no underlying economics and throwing off no cash flow to the benefit of its owner (see investment) 

Spinoff—the distribution of the shares of a subsidiary company to the shareholders of the parent company 

Stock—a marketable piece of paper representing the fractional ownership of an underlying business 

Stock index Futures—contracts for the future delivery of a market basket of stocks 

Stock market proxy—estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market 

Subordinated-debt security - security with a secondary priority in the hierarchy of a company’s capital structure 

Tactical-asset allocation—computer program designed to indicate whether stocks or bonds are a better buy 

Takeover multiple— multiple of earnings, cash flow, or revenues paid to acquire a company 

Tangible asset—an asset physically in existence

Glossary (5)

  Glossary

Net operating-loss carryforward (NOL)—the carryforward of past losses for tax purposes, enabling a company to shield future income from taxation 

Net present value (NPV)—calculation of the value of an investment by discounting future estimates of cash flow back to the present 

Non-cash-pay securities—securities permitted to pay interest or dividends in kind or at a later date rather than in cash as due (see cash-pay securities, pay-in-kind, and zero-coupon bond) 

Nonrecourse—the lender looks only to the borrowing entity for payment 

Open end mutual fund—mutual fund offering to issue or redeem shares at a price equal to underlying net asset value 

Opportunity cost—the loss represented by forgone opportunities 

Option—the right to buy (call) or sell (put) specified items at specified prices by specified dates 

Over-the-counter (OTC)—the market for stocks not listed on a securities exchange (e.g., New York, American, Philadelphia, Boston, Pacific, Toronto) 

Par—the face amount of a bond; the contractual amount of the bondholder’s claim 

Pay-in-kind (PIK)—a security paying interest or dividends in kind rather than in cash 

Plan of reorganization—the terms under which a company expects to emerge from Chapter 11 bankruptcy 

Portfolio cash flow—the cash flowing into a portfolio net of outflows 

Portfolio insurance—a strategy involving the periodic sale of stock-index futures designed to eliminate downside risk in a portfolio at a minor up-front cost 

Post petition interest—interest accruing from the date of a bankruptcy filing forward 

Preferred stock—an equity security senior in priority to common stock with a specified entitlement to dividend payments 

Prepackaged bankruptcy—a technique whereby each class of creditors in a bankruptcy agree on a plan of reorganization prior to the bankruptcy filing 

Prepetition interest—interest accruing from the most recent coupon payment up to the date of a bankruptcy filing 

Price/earnings (P/E) ratio—market price of a stock divided by the annualized earnings per share 

Price-to-book-value ratio—market price of a stock divided by book value per share 

Principal— the face amount or par value of a debt security 

Principal-only mortgage security (PO)—principal payments stripped from a pool of mortgages which, in response to changes in interest rates, fluctuate in value in the same direction as conventional mortgages but with greater volatility 

Private-market value—the price that a sophisticated businessperson would be likely to pay for a business based on the valuation multiples paid on similar transactions 

Pro forma financial information —earnings and book value adjusted to reflect a recent or proposed merger, recapitalization, tender offer, or other extraordinary transaction 

Proxy contest—a fight for corporate control through the solicitation of proxies or the election of directors 

Prudent-man standard—the obligation under ERISA to restrict one’s investments to those a “prudent” (conservative) person would make (see Employee Retirement Income Security Act of 1974 (ERISA) 

Put option—a contract enabling the purchaser to sell a security at a fixed price on a particular date

Glossary (4)

 Glossary

Inside information—information unavailable to the public, upon which it is illegal to base transactions 

Institutional investors —money managers, pension fund managers, and managers of mutual funds 

Intangible asset—an asset without physical presence; examples include intellectual property rights (patents) or going-concern value (goodwill) 

Interest—payment for the use of borrowed money 

Interest-coverage ratio—the ratio of pretax earnings to interest expense 

Interest-only mortgage security (IO)—interest payments stripped from a pool of mortgages which, for a given change in interest rates, fluctuates in value inversely to conventional mortgages (see principal-only mortgage security) 

Interest rate reset—a promise made by an issuer to adjust the coupon on a bond at a specified future date in order to cause it to trade at a predetermined price 

Internal rate of return (IRR)—calculation of the rate of return of an investment that assumes reinvestment of cash flows at the same rate of return the investment itself offers 

Investment—an asset purchased to provide a return; investments, in contrast to speculations, eventually generate cash flow for the benefit of the owners (see speculation) 

Investment banking—profession involving raising capital for companies as well as underwriting and trading securities, arranging for the purchase and sale of entire companies, providing financial advice, and opining on the fairness of specific transactions 

Investment grade—fixed income security rated BBB or higher 

Junk bond - fixed-income security rated below investment grade 

Leveraged buyout (LBO)—acquisition of a business by an investor group relying heavily on debt financing 

Liability—a debt or other obligation to pay 

Liquidating distribution—cash or securities distributed to shareholders by a company in the process of liquidation 

Liquidating trust—an entity established to complete a corporate liquidation 

Liquidation value—the expected proceeds if the assets of a company were sold off, but not as part of an ongoing enterprise 

Liquidity—having ample cash on hand 

Liquid security—a security that trades frequently and within a narrow spread between the bid and asked prices 

Making a market—acting as a securities dealer by simultaneously bidding for and offering a security 

Margin of safety—investing at considerable discounts from underlying value, an individual provides himself or herself room for imprecision, bad luck, or analytical error (i.e., a “margin of safety”) while avoiding sizable losses 

Market price—the price of the most recent transaction in a company’s publicly traded stock or bonds 

Maturity—the date on which the face value of a debt security is due and payable 

Merchant banking—an activity whereby Wall Street firms commit their own capital while acting as principal in investment banking transactions 

Merger—a combination of two corporations into one 

Mutual fund—a pooled investment portfolio managed by professional investors 

Net asset value (NAV)—the per share value of a mutual fund calculated by dividing the total market value of assets by the number of shares outstanding 

Net-net working capital—net working capital less all long-term liabilities 

Glossary (3)

 Glossary

Efficient— market hypothesis-speculative notion that all information about securities is disseminated and becomes fully reflected in security prices instantaneously 

Employee Retirement Income Security Act of 1974 (ERISA)—legislation that requires institutional investors to act as fiduciaries for future retirees by adopting the “prudent-man standard” (see prudent-man standard) 

Equity “stubs”—low priced, highly leveraged stocks, often resulting from a corporate recapitalization (see recapitalization) 

Exchange offer—an offer made by a company to its security holders to exchange new, less-onerous securities for those outstanding 

“Fallen angels”—bonds of companies that have deteriorated beneath investment grade in credit quality 

Financial distress—the condition of a business experiencing a shortfall of cash to meet operating needs and scheduled debt-service requirements 

Friendly takeover—corporate acquisition in which the buyer and seller both support the transaction enthusiastically 

Fulcrum securities—the class of securities whose strict priority bankruptcy claim is most immediately affected by changes in the debtor’s value 

Full position—ownership of as much of a given security as an investor is willing to hold 

Fundamental analysis— analyzing securities based on the operating performance (fundamentals) of the underlying business 

Ginnie Mae (GNMA)—pool of mortgages insured by the Government National Mortgage Association, a U.S. government agency 

Going long —buying a security (see short-selling) 

Goodwill amortization—the gradual expensing of the intangible asset known as goodwill, which comes into existence when a company is purchased for more than its tangible book value 

Guaranteed investment contract (GIC)—an insurance-company-sponsored investment product that automatically reinvests interest at a contractual rate 

Hedge—an investment that, by appreciating (depreciating) inversely to another, has the effect of cushioning price changes in the latter 

Holding company—a corporate structure in which one company (the holding company) is the owner of another 

Hold-up value— benefits accruing to participants in a class of securities who are able to extract considerable nuisance value from the holders of other classes of securities 

Illiquid security—a security that trades infrequently, usually with a large spread between the bid and asked prices (see liquid security) 

Income statement—accounting statement calculating a company’s profit or loss 

Indexing—the practice of buying all the components of a market index, such as the Standard and Poor’s 500 index, in proportion to the weightings of that index and then passively holding them 

Initial public offering (IPO)—underwriting of a stock being offered to the public for the first time

Glossary (2)

 Glossary 

Catalyst—an internally or externally instigated corporate event that results in security holders realizing some or all of a company’s underlying value 

Chapter 11—a section of the federal bankruptcy code whereby a debtor is reorganized as a going concern rather than liquidated (see bankruptcy) 

Closed-end mutual fund—mutual fund having a fixed number of outstanding shares that trade based on supply and demand at prices not necessarily equal to underlying net asset value (see open-end mutual fund) 

Collateralized bond obligation (CBO)—diversified investment pools of junk bonds that issue their own securities, usually in several tranches, each of which has risk and return characteristics that differ from those of the underlying junk bonds themselves 

Commercial paper—short-term loans from institutional investors to businesses 

Commission—a charge for transacting in securities 

Complex securities—securities with unusual cash flow characteristics 

Contingent-value rights—tradable rights that are redeemable for cash if a stock fails to reach specified price levels 

Convertible arbitrage—arbitrage transactions designed to take advantage of price discrepancies between convertible securities and the securities into which they are convertible 

Convertible bonds—bonds that can be exchanged for common stock or other assets of a company at a specified price 

Coupon—the specified interest payment on a bond expressed as a percentage 

Covered-call writing—the practice of purchasing common stocks and then selling call options against them 

Cram-down security—security distributed in a merger transaction, not sold by an underwriter 

Credit cycle—the ebb and flow in the availability of credit 

Debtor-in-possession (DIP) financing—loan to a bankrupt company operating in Chapter 11 

Debt-to-equity ratio—the ratio of a company’s outstanding debt to the book value of its equity; a measure of a company’s financial leverage 

Default—the status of a company that fails to make an interest or principal payment on a debt security on the required date 

Default rate of junk bonds—calculated by many junk-band-market participants as the dollar volume of junk-bond defaults occurring in a particular year divided by the total volume of junk bonds outstanding 

Depreciation—an accounting procedure by which long-lived assets are capitalized and then expensed over time 

Discount rate—the rate of interest that would make an investor indifferent between present and future dollars 

Diversification—ownership of many rather than a small number of securities; the goal of diversification is to limit the risk of company-specific events on one’s portfolio as a whole 

Dividend—cash distributed by a company to its shareholders out of after-tax earnings 

Earnings before interest, taxes, depreciation, and amortization (EBITDA)—a nonsensical number thought by some investors to represent the cash flow of a business 

Earnings per share—a company’s after-tax earnings divided by the total number of shares outstanding

Glossary (1)

Glossary 

Absolute-performance orientation—the tendency to evaluate investment results by measuring one’s investment performance against an absolute standard such as the risk-free rate of return 

Annuity—a stream of cash in perpetuity 

Arbitrage— the practice of investing in risk-free transactions to take advantage of pricing discrepancies between markets (see risk arbitrage) 

Arbitrageur—investor in risk-arbitrage transactions 

Asked price (offer)—the price at which a security is offered for sale (see bid price) 

Asset—something owned by a business or individual 

Average down—to buy more of a security for less than one’s earlier purchase price(s), resulting in a reduction of the average cost 

Balance sheet— accounting statement of a company’s assets, liabilities, and net worth 

Bankruptcy—a legal state wherein a debtor (borrower) is temporarily protected from creditors (lenders); under Chapter 11 of the federal bankruptcy code, companies may continue to operate 

Bear market—an environment characterized by generally declining share prices (see bull market) 

Beta—a statistical measure used by some academics and market professionals to quantify investment risk by comparing a security’s or portfolio’s historical price performance with that of the market as a whole 

Bid price—the price a potential buyer is willing to pay for a security (see asked price) 

Blocking position—the ownership of a sufficient percentage of a class of securities to prevent undesirable actions from occurring (a creditor owning one-third or more of a class of bankrupt debt securities is able to “block” approval of a plan of reorganization not to his or her liking) 

Bond—a security representing a loan to a business or government entity 

Book value—the historical accounting of shareholders’ equity; this is, in effect, the residual after liabilities are subtracted from assets 

Bottom—up investing-strategy involving the identification of specific undervalued investment opportunities one at a time through fundamental analysis 

Breakup value—the expected proceeds if the assets of a company were sold to the highest bidder, whether as a going concern or not (see liquidation value) 

Bull market—an environment characterized by generally rising share prices (see bear market) 

Callable bond—a bond that may be retired by the issuer at a specified price prior to its contractual maturity (see puttable bond) 

Call option—a contract enabling the owner to purchase a security at a fixed price on a particular date (see put option) 

Cash flow—the cash gain or loss experienced by a business during a particular period of operations 

Cash-pay securities—securities required to make interest or dividend payments in cash (see non-cash-pay securities)

Investment Research and Inside Information

How far is it reasonable to go in pursuit of information

The investment research process is complicated by the blurred line between publicly available and inside, or privileged, information. 

Although trading based on inside information is illegal, the term has never been clearly defined. 

As investors seek to analyze investments and value securities, they bump into the unresolved question of how far they may reasonably go in the pursuit of information. 

• For example, can an investor presume that information provided by a corporate executive is public knowledge (assuming, of course, that suitcases of money do not change hands)? 
• Similarly, is information that emanates from a stockbroker in the public domain? 
• How about information from investment bankers? 
• If not the latter, then why do investors risk talking to them, and why are the investment bankers willing to speak? 

How far may investors go in conducting fundamental research? 

• How deep may they dig? 
• May they hire private investigators, and may those investigators comb through a company’s garbage?
• What, if any, are the limits? 

Do different rules apply to equities than to other securities? 

Debt market

The troubled debt market, for example, is event driven. 

Takeovers, exchange offers, and open-market bond repurchases are fairly routine. 

What is public knowledge, and what is not? 

• If you sell bonds back to a company, which then retires them, is knowledge of that trade inside information? 
• Does it matter how many bonds were sold or when the trade occurred? 
• If this constitutes inside information, in what way does it restrict you? 
• If you are a large bondholder and the issuer contacts you to discuss an exchange offer, in what way can that be construed as inside information? 

When does inside information become sufficiently old to no longer be protected? 

• When do internal financial projections become outdated? 
• When do aborted merger plans cease to be secret? 

There are no firm answers to these questions. 

Stay within the law, err on the side of ignorance or seek advice

Investors must bend over backward to stay within the law, of course, but it would be far easier if the law were more clearly enunciated. 

Since it is not, law abiding investors must err on the side of ignorance, investing with less information than those who are not so ethical. 

When investors are unsure whether they have crossed the line, they would be well advised to ask their sources and perhaps their attorneys as well before making any trades. 

Conclusion 

Investment research is the process of reducing large piles of information to manageable ones, distilling the investment wheat from the chaff. 

There is, needless to say, a lot of chaff and very little wheat. 

The research process itself, like the factory of a manufacturing company, produces no profits. 

The profits materialize later, often much later, when the undervaluation identified during the research process is first translated into portfolio decisions and then eventually recognized by the market. 

In fact, often there is no immediate buying opportunity; today’s research may be advance preparation for tomorrow’s opportunities. 

In any event, just as a superior sales force cannot succeed if the factory does not produce quality goods, an investment program will not long succeed if high-quality research is not performed on a continuing basis.

Insider Buying and Management Stock Options Can Signal Opportunity

Only one reason for insider buying

In their search for complete information on businesses, investors often overlook one very important clue. In most instances no one understands a business and its prospects better than the management. 

Therefore investors should be encouraged when corporate insiders invest their own money alongside that of shareholders by purchasing stock in the open market. 

It is often said on Wall Street that there are many reasons why an insider might sell a stock (need for cash to pay taxes, expenses, etc.), but there is only one reason for buying. 

Investors can track insider buying and selling in any of several specialized publications, such as Vickers Stock Research. 

Management stock-options provide the specific incentive to boost the company's share price

The motivation of corporate management can be a very important force in determining the outcome of an investment. 

Some companies provide incentives for their managements with stock-option plans and related vehicles. 

Usually these plans give management the specific incentive to do what they can to boost the company’s share price. 

Be alert to the motivations of managements at the companies

While management does not control a company’s stock price, it can greatly influence the gap between share price and underlying value and over time can have a significant influence on value itself. 

If the management of a company were compensated based on revenues, total assets, or even net income, it might ignore share price while focusing on those indicators of corporate performance. 

If, however, management were provided incentives to maximize share price, it would focus its attention differently. 

• For example, the management of a company whose stock sold at $25 with an underlying value of $50 could almost certainly boost the market price by announcing a spinoff, recapitalization, or asset sale, with the result of narrowing the gap between share price and underlying value. 
• The repurchase of shares on the open market at $25 would likely give a boost to the share price as well as causing the underlying value of remaining shares to increase above $50. 

Obviously investors need to be alert to the motivations of managements at the companies in which they invest.

How Much Research and Analysis Are Sufficient?

 Two shortcomings on trying to obtain perfect knowledge

Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. 

They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. 

They analyze financial statements for the past decade and stock price trends for even longer. 

This diligence is admirable, but it has two shortcomings. 

• First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information. 
• Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit. 

80/20 rule

This is not to say that fundamental analysis is not useful. It certainly is. 

But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. 

The value of in-depth fundamental analysis is subject to diminishing marginal returns. 

Information is not always easy to obtain.

Some companies actually impede its flow. Understandably, proprietary information must be kept confidential. 

The requirement that all investors be kept on an equal footing is another reason for the limited dissemination of information; information limited to a privileged few might be construed as inside information. 

Restrictions on the dissemination of information can complicate investors’ quest for knowledge nevertheless. 

Business information is highly perishable.

Moreover, business information is highly perishable. 

Economic conditions change, industries are transformed, and business results are volatile. 

The effort to acquire current, let alone complete information is never-ending. 

Meanwhile, other market participants are also gathering and updating information, thereby diminishing any investor’s informational advantage. 

David Dreman recounts “the story of an analyst so knowledgeable about Clorox that ‘he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox’s line number 2, plant number 3. But somehow, when the company began to develop massive problems, he missed the signs....’ The stock fell from a high of 53 to 11.” 

Wall Street analysts' recommendations may be less than stellar

Although many Wall Street analysts have excellent insight into industries and individual companies, the results of investors who follow their recommendations may be less than stellar. In part this is due to the pressure placed on these analysts 

• to recommend frequently rather than wisely, but 
• it also exemplifies the difficulty of translating information into profits. 

Industry analysts are not well positioned to evaluate the stocks they follow in the context of competing investment alternatives. 

• Merrill Lynch’s pharmaceutical analyst may know everything there is to know about Merck and Pfizer, but he or she knows virtually nothing about General Motors, Treasury bond yields, and Jones & Laughlin Steel first-mortgage bonds. 

Investors frequently benefit from uncertainty and making decision with less than perfect knowledge

Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain.  

Yet high uncertainty is frequently accompanied by low prices.  By the time the uncertainty is resolved, prices are likely to have risen. 

Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. 

The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

Value Investing and Contrarian Thinking

Value investing by its very nature is contrarian. 

Out-of-favor securities may be undervalued; popular securities almost never are. 

What the herd is buying is, by definition, in favor. 

Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked. 

Where may value exist?

If value is not likely to exist in what the herd is buying, where may it exist? 

In what they are 

• selling, 
• unaware of, or 
• ignoring. 

When the herd is selling a security, the market price may fall well beyond reason. 

Ignored, obscure, or newly created securities may similarly be or become undervalued. 

Contrarians are almost always initially wrong

Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. 

Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. 

By contrast, members of the herd are nearly always right for a period. 

Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value. 

When contrary opinion can be put to use.

Holding a contrary opinion is not always useful to investors, however. 

1.  When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. 

• It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. 

2.  By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use. 

• When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/ reward ratio, allowing contrarians to bet against the crowd with the odds skewed in their favor. 
• When investors in 1983 either ignored or panned the stock of Nabisco, causing it to trade at a discount to other food companies, the risk/reward ratio became more favorable, creating a buying opportunity for contrarians. 

Market Inefficiencies and Institutional Constraints cause stocks to sell at depressed prices

Ask:  Why the bargain has become available?

The research task does not end with the discovery of an apparent bargain. It is incumbent on investors to try to find out why the bargain has become available. 

• If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. 
• If you learned of one available for $150,000, your first reaction would not have been, “What a great bargain!” but, “What’s wrong with it?” 

A bargain should be inspected and re-inspected for possible flaws.

The same healthy skepticism applies to the stock market. A bargain should be inspected and re-inspected for possible flaws. 

• Irrational or indifferent selling alone may have made it cheap, but there may be more fundamental reasons for the depressed price. 
• Perhaps there are contingent liabilities or pending litigation that you are unaware of. 
• Maybe a competitor is preparing to introduce a superior product. 

When reason for undervaluation can be clearly identified, the outcome is more predictable

When the reason for the undervaluation can be clearly identified, it becomes an even better investment because the outcome is more predictable. 

• By way of example, the legal constraint that prevents some institutional investors from purchasing low-priced spinoffs is one possible explanation for undervaluation. Such reasons give investors some comfort that the price is not depressed for an undisclosed fundamental business reason. 
• Other institutional constraints can also create opportunities for value investors. For example, many institutional investors become major sellers of securities involved in risk-arbitrage transactions on the grounds that their mission is to invest in ongoing businesses, not speculate on takeovers. The resultant selling pressure can depress prices, increasing the returns available to arbitrage investors. 
• Institutional investors are commonly unwilling to buy or hold low-priced securities. Since any company can exercise a degree of control over its share price through splitting or reverse splitting its outstanding shares, the financial rationale for this constraint is hard to understand. Why would a company’s shares be a good buy at $15 a share but not at $3 after a five for-one stock split or vice versa? 

Market inefficiencies cause stocks to sell at depressed levels

1.  Obscurity and a very thin market can cause stocks to sell at depressed levels. 

Many attractive investment opportunities result from market inefficiencies, that is, areas of the security markets in which information is not fully disseminated or in which supply and demand are temporarily out of balance. 

Almost no one on Wall Street, for example, follows, let alone recommends, small companies whose shares are closely held and infrequently traded; there are at most a handful of market makers in such stocks. Depending on the number of shareholders, such companies may not even be required by the SEC to file quarterly or annual reports. 

2.  Year-end tax selling also creates market inefficiencies. 

• The Internal Revenue Code makes it attractive for investors to realize capital losses before the end of each year. 
• Selling driven by the calendar rather than by investment fundamentals frequently causes stocks that declined significantly during the year to decline still further. 
• This generates opportunities for value investors.

Knowing where to look for opportunities to invest

Investment Research: The Challenge of Finding Attractive Investments 

Investors are in the business of processing information

While knowing how to value businesses is essential for investment success, the first and perhaps most important step in the investment process is knowing where to look for opportunities. 

Investors are in the business of processing information, but while studying the current financial statements of the thousands of publicly held companies, the monthly, weekly, and even daily research reports of hundreds of Wall Street analysts, and the market behavior of scores of stocks and bonds, they will spend virtually all their time reviewing fairly priced securities that are of no special interest. 

Good investment ideas are rare

Good investment ideas are rare and valuable things, which must be ferreted out assiduously. They do not fly in over the transom or materialize out of thin air. Investors cannot assume that good ideas will come effortlessly 

• from scanning the recommendations of Wall Street analysts, no matter how highly regarded, or 
• from punching up computers, no matter how cleverly programmed, 

although both can sometimes indicate interesting places to hunt. 

Upon occasion attractive opportunities are so numerous that the only limiting factor is the availability of funds to invest; typically the number of attractive opportunities is much more limited. 

By identifying where the most attractive opportunities are likely to arise before starting one’s quest for the exciting handful of specific investments, investors can spare themselves an often fruitless survey of the humdrum majority of available investments. 

Three categories of specialized investment niches

Value investing encompasses a number of specialized investment niches that can be divided into three categories: 

• securities selling at a discount to breakup or liquidation value, 
• rate-of-return situations, and 
• asset-conversion opportunities. 

Where to look for opportunities

Where to look for opportunities varies from one of these categories to the next. 

1.  Computer-screening techniques, for example, can be helpful in identifying stocks of the first category: those selling at a discount from liquidation value. Because databases can be out of date or inaccurate, however, it is essential that investors verify that the computer output is correct. 

2.  Risk arbitrage and complex securities comprise a second category of attractive value investments with known exit prices and approximate time frames, which, taken together, enable investors to calculate expected rates of return at the time the investments are made. 

• Mergers, tender offers, and other risk arbitrage transactions are widely reported in the daily financial press – the Wall Street Journal and the business section of the New York Times – as well as in specialized newsletters and periodicals. 
• Locating information on complex securities is more difficult, but as they often come into existence as byproducts of risk arbitrage transactions, investors who follow the latter may become aware of the former. 

3.  Financially distressed and bankrupt securities, corporate recapitalizations, and exchange offers all fall into the category of asset conversions, in which investors’ existing holdings are exchanged for one or more new securities. 

• Distressed and bankrupt businesses are often identified in the financial press; specialized publications and research services also provide information on such companies and their securities. 
• Fundamental information on troubled companies can be gleaned from published financial statements and in the case of bankruptcies, from court documents. 
• Price quotations may only be available from dealers since many of these securities are not listed on any exchange. 
• Corporate recapitalizations and exchange offers can usually be identified from a close reading of the daily financial press. Publicly available filings with the Securities and Exchange Commission (SEC) provide extensive detail on these extraordinary corporate transactions. 

4.  Many undervalued securities do not fall into any of these specialized categories and are best identified through old fashioned hard work, yet there are widely available means of improving the likelihood of finding mispriced securities. 

• Looking at stocks on the Wall Street Journal’s leading percentage-decline and new-low lists, for example, occasionally turns up an out-of-favor investment idea. 
• Similarly, when a company eliminates its dividend, its shares often fall to unduly depressed levels. 
• Of course, all companies of requisite size produce annual and quarterly reports, which they will send upon request. Filings of a company’s annual and quarterly financial statements on Forms 10K and 10Q, respectively, are available from the SEC and often from the reporting company as well. 

Niche opportunities sometimes emerges

Sometimes an attractive investment niche emerges in which numerous opportunities develop over time. One such area has been the large number of thrift institutions that have converted from mutual to stock ownership.

• Investors should consider analyzing all companies within such a category in order to identify those that are undervalued. 
• Specialized newsletters and industry periodicals can be excellent sources of information on such niche opportunities.

You must predict the future, yet the future is not reliably predictable.

The difficulty of predicting the future even a few years ahead. 

An unresolvable contradiction exists: to perform present value analysis, you must predict the future, yet the future is not reliably predictable. 

The miserable failure in 1990 of highly leveraged companies such as Southland Corporation and Interco, Inc., to meet their own allegedly reasonable projections made just a few years earlier-in both cases underperforming by more than 50 percent-highlights the difficulty of predicting the future even a few years ahead. 

Investors are often overly optimistic in their assessment of the future. 

A good example of this is the common response to corporate write-offs. This accounting practice enables a company at its sole discretion to clean house, instantaneously ridding itself of underperforming assets, uncollectible receivables, bad loans, and the costs incurred in any corporate restructuring accompanying the write-off. 

Typically such moves are enthusiastically greeted by Wall Street analysts and investors alike; post-write-off the company generally reports a higher return on equity and better profit margins. Such improved results are then projected into the future, justifying a higher stock market valuation. 

Investors, however, should not so generously allow the slate to be wiped clean. When historical mistakes are erased, it is too easy to view the past as error free. It is then only a small additional step to project this error-free past forward into the future, making the improbable forecast that no currently profitable operation will go sour and that no poor investments will ever again be made. 

How do value investors deal with the analytical necessity to predict the unpredictable? 

The only answer is conservatism. 

Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. 

Conservative forecasts can be more easily met or even exceeded. 

Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.

Many factors can derail any business forecast.

Forecasting future growth is considerably imprecise

Forecasting sales or profits many years into the future is considerably more imprecise, and a great many factors can derail any business forecast. 

There are many investors who make decisions solely on the basis of their own forecasts of future growth. After all, the faster the earnings or cash flow of a business is growing, the greater that business’s present value. 

Difficulties confronting growth-oriented investors

Yet several difficulties confront growth-oriented investors. 

• First, such investors frequently demonstrate higher confidence in their ability to predict the future than is warranted. 
• Second, for fast-growing businesses even small differences in one’s estimate of annual growth rates can have a tremendous impact on valuation.  
• Moreover, with so many investors attempting to buy stock in growth companies, the prices of the consensus choices may reach levels unsupported by fundamentals. 
• Investors may at times be lured into making overly optimistic projections based on temporarily robust results, thereby causing them to overpay for mediocre businesses. 
• When growth is anticipated and therefore already discounted in securities prices, shortfalls will disappoint investors and result in share price declines.

When a good business can become a bad investment

 As Warren Buffett has said, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.” 

Growth investors tend to oversimplify growth into a single number

Another difficulty with investing based on growth is that while investors tend to oversimplify growth into a single number, growth is, in fact, comprised of numerous moving parts which vary in their predictability. 

Sources of earnings growth

For any particular business, for example, earnings growth can stem from increased unit sales related 

• to predictable increases in the general population, 
• to increased usage of a product by consumers, 
• to increased market share, 
• to greater penetration of a product into the population, or 
• to price increases. 

Specifically, a brewer might expect to sell more beer as the drinking-age population grows but would aspire to selling more beer per capita as well. Budweiser would hope to increase market share relative to Miller. The brewing industry might wish to convert whiskey drinkers into beer drinkers or reach the abstemious segment of the population with a brand of nonalcoholic beer. Over time companies would seek to increase price to the extent that it would be expected to result in increased profits. 

Some of these sources of earnings growth are more predictable than others. 

• Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behavior, such as the conversion of whiskey drinkers to beer. 
• The reaction of customers to price increases is always uncertain. 

On the whole it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialize and how it will affect profits. 

Difficulty of Forecasting Future Cash Flow

Present-Value Analysis and the Difficulty of Forecasting Future Cash Flow 

When future cash flows are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. 

Unfortunately future cash flows are usually uncertain, often highly so.  Moreover, the choice of a discount rate can be somewhat arbitrary. 

These factors together typically make present-value analysis an imprecise and difficult task. 

 

A perfect business that is simple to value: an annuity

A perfect business in terms of the simplicity of valuation would be an annuity; an annuity generates an annual stream of cash that either remains constant or grows at a steady rate every year. 

For real businesses, estimating its future cash flow is usually a guessing game

Real businesses, even the best ones, are unfortunately not annuities. 

Few businesses occupy impenetrable market niches and generate consistently high returns, and most are subject to intense competition. 

Small changes in either revenues or expenses cause far greater percentage changes in profits. The number of things that can go wrong greatly exceeds the number that can go right.

Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game. 

A recurring theme is that the future is not predictable, except within fairly wide boundaries. 

Business uncertainty - the roles of management and investors

Responding to business uncertainty is the job of corporate management. 

However, controlling or preventing uncertainty is generally beyond management’s ability and should not be expected by investors.  

Three useful yardsticks of business value

 Business Valuation 

To be a value investor, you must buy at a discount from underlying value. 

Analyzing each potential value investment opportunity therefore begins with an assessment of business value. 

While a great many methods of business valuation exist, there are only three that I find useful. 

1.  NPV

The first is an analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate. 

[Using multiples.  A frequently used but flawed shortcut method of valuing a going concern is known as private-market value. This is an investor’s assessment of the price that a sophisticated businessperson would be willing to pay for a business. Investors using this shortcut, in effect, value businesses using the multiples paid when comparable businesses were previously bought and sold in their entirety. ]

2.  Liquidation value

The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off. Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not. 

3.  Stock market value

The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value. 

Conclusions:

Each of these methods of valuation has strengths and weaknesses. 

None of them provides accurate values all the time. 

Unfortunately no better methods of valuation exist. 

Investors have no choice but to consider the values generated by each of them; when they appreciably diverge, investors should generally err on the side of conservatism.

The concept of a range of value:

Businesses, unlike debt instruments, do not have contractual cash flows. As a result, they cannot be as precisely valued as bonds. 

In Security Analysis Benjamin Graham and David Dodd discussed the concept of a range of value:

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that 

• the value is adequate – e.g., to protect a bond or to justify a stock purchase – or 
• else that the value is considerably higher or considerably lower than the market price. 

For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.

Graham frequently performed a calculation known as net working capital per share, a back-of-the-envelope estimate of a company’s liquidation value. His use of this rough approximation was a tacit admission that he was often unable to ascertain a company’s value more precisely.

Benjamin Graham knew how hard it is to pinpoint the value of businesses and thus of equity securities that represent fractional ownership of those businesses.

A Range of Value

 A Range of Value

Businesses, unlike debt instruments, do not have contractual
cash flows. As a result, they cannot be as precisely valued as
bonds. 

Benjamin Graham knew how hard it is to pinpoint the
value of businesses and thus of equity securities that represent
fractional ownership of those businesses. In Security Analysis he
and David Dodd discussed the concept of a range of value:

The essential point is that security analysis does not seek to
determine exactly what is the intrinsic value of a given security.
It needs only to establish that the value is adequate – e.g., to
protect a bond or to justify a stock purchase – or else that the
value is considerably higher or considerably lower than the
market price. For such purposes an indefinite and approximate

measure of the intrinsic value may be sufficient.

Indeed, Graham frequently performed a calculation known as
net working capital per share, a back-of-the-envelope estimate
of a company’s liquidation value. His use of this rough
approximation was a tacit admission that he was often unable
to ascertain a company’s value more precisely.

To illustrate the difficulty of accurate business valuation,
investors need only consider the wide range of Wall Street
estimates that typically are offered whenever a company is put
up for sale. 

In 1989, for example, Campeau Corporation
marketed Bloomingdales to prospective buyers; Harcourt Brace
Jovanovich, Inc., held an auction of its Sea World subsidiary;
and Hilton Hotels, Inc., offered itself for sale. In each case Wall
Street’s value estimates ranged widely, with the highest
estimate as much as twice the lowest figure. If expert analysts
with extensive information cannot gauge the value of high 

profile, well-regarded businesses with more certainty than this,
investors should not fool themselves into believing they are
capable of greater precision when buying marketable securities
based only on limited, publicly available information.

Markets exist because of differences of opinion among

investors. If securities could be valued precisely, there would be
many fewer differences of opinion; market prices would
fluctuate less frequently, and trading activity would diminish.
To fundamentally oriented investors, the value of a security to
the buyer must be greater than the price paid, and the value to
the seller must be less, or no transaction would take place. The
discrepancy between the buyer’s and the seller’s perceptions of
value can result from such factors as differences in assumptions
regarding the future, different intended uses for the asset, and
differences in the discount rates applied. Every asset being

bought and sold thus has a possible range of values bounded by
the value to the buyer and the value to the seller; the actual
transaction price will be somewhere in between.

In early 1991, for example, the junk bonds of Tonka
Corporation sold at steep discounts to par value, and the stock
sold for a few dollars per share. The company was offered for
sale by its investment bankers, and Hasbro, Inc., was evidently
willing to pay more for Tonka than any other buyer because of
economies that could be achieved in combining the two
operations. Tonka, in effect, provided appreciably higher cash
flows to Hasbro than it would have generated either as a 

standalone business or to most other buyers. There was a sharp
difference of opinion between the financial markets and Hasbro
regarding the value of Tonka, a disagreement that was resolved
with Hasbro’s acquisition of the company.

The Art of Business Valuation. BUSINESS VALUE IS IMPRECISIVELY KNOWABLE.

 

BUSINESS VALUE IS IMPRECISIVELY KNOWABLE

Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined. 

Reported book value, earnings, and cash flow are, after all, only the best guesses of accountants who follow a fairly strict set of standards and practices designed more to achieve conformity than to reflect economic value. 

Projected results are less precise still. 

You cannot appraise the value of your home to the nearest thousand dollars. Why would it be any easier to place a value on vast and complex businesses?

BUSINESS VALUE CHANGES OVER TIME.  REQUIRES CONTINUOUS REASSESSMENTS.

Not only is business value imprecisely knowable, it also changes over time, fluctuating with numerous macroeconomic, microeconomic, and market-related factors. So while investors at any given time cannot determine business value with precision, they must nevertheless almost continuously reassess their estimates of value in order to incorporate all known factors that could influence their appraisal.

Any attempt to value businesses with precision will yield values that are precisely inaccurate. The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones. 

Anyone with a simple, handheld calculator can perform net present value (NPV) and internal rate of return (IRR) calculations. 

• The NPV calculation provides a single-point value of an investment by discounting estimates of future cash flow back to the present. 
• IRR, using assumptions of future cash flow and price paid, is a calculation of the rate of return on an investment to as many decimal places as desired.

NPV AND IRR ARE ONLY AS ACCURATE AS THE CASH FLOW ASSUMPTIONS USED

The seeming precision provided by NPV and IRR calculations can give investors a false sense of certainty for they are really only as accurate as the cash flow assumptions that were used to derive them.

The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful analysis, even for the most haphazard of efforts. Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions. 

“Garbage in, garbage out” is an apt description of the process. 

NPV and IRR are wonderful at summarizing, in absolute and percentage terms, respectively, the returns for a given series of cash flows. 

When cash flows are contractually determined, as in the case of a bond, and when all payments are received when due, 

• IRR provides the precise rate of return to the investor while 
• NPV describes the value of the investment at a given discount rate. 

In the case of a bond, these calculations allow investors to quantify their returns under one set of assumptions, that is, that contractual payments are received when due. 

These tools, however, are of no use in determining the likelihood that investors will actually receive all contractual payments and, in fact, achieve the projected returns.