Friday 10 October 2014
Analysing the substance and character of a business is the holy grail of investing. Guessing a price that someone else is willing to pay, is not.
By 1969, the stock market had reached new highs, and the Buffett Partnership continued to beat its returns. As the market continued to climb even higher, Buffett announced that he would close his partnerships. He told the partners that the speculation-driven stock market didn't make sense; he wanted no part of the folly.
Buffett sold everything in the portfolio except for shares in Diversified Retailing, Blue Chip Stamps, and Berkshire Hathaway, which now included insurance and banking businesses as well as equity investments. Avoiding the speculative market, Buffett continued to hunt for attractive underated businesses. In 1971, he bought a controlling interest in See's Candies.
By early January 1973, the Dow had climbed to an all time high of 1,051 points. But only $17 million of Berkshire's $101 million insurance portfolio was invested in stocks; the rest was in bonds. Not long after this high, the market swooned. The it racheted down further. By October 1974, it hit a low of 580 points. Investors panicked but Buffett rejoiced. He was in his elements once again.
Over the following years, Buffett bagged big game at bargain prices, adding Wesco Financial and buying large blocks of stocks in The Washington Post and Geico. In 1977, Buffett bought The Buffalo News.
Buffett's belief that analysing the substance and character of a business was the holy grail of investing. Guessing a price that someone else was willing to pay - irrespective of fundamentals - was not.
Cinderella at the Ball. Warning investors about the "sedation of effortless money".
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large dose of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities - that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future - will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before mid-night. There's a problem, though: They are dancing in a room in which the clocks have no hands.
Warren Buffett's Cinderella parable in his 2000 shareholder letter.
Warren Buffett's Cinderella parable in his 2000 shareholder letter.
In a financial crisis, when banks cannot lend, cash is particularly valuable.
Buffett is a balance sheet guy. That's where the cash is reported. Cash is the fuel that drives economic value.
Most CEOs, however, focus on growth in corporate profits more than on cash and balance sheet growth. The source of the problem is: some of the reported expenses in these income statements are cash, and some are determined by accounting rules. As a result, earnings include both cash and noncash (i.e., "accounting") numbers. Buffett cares most about the cash part.
Cash is real. Noncash earnings are subject to accounting interpretations. They can be adjusted to inflate earnings and boost the stock price. But it is harder to fiddle with the cash numbers.
Buffett's long-term cash obsession creates unique opportunities that others miss. Buffett keeps a lot of cash on hand in order to be ready for unique crisis-born opportunities. "Do we panic when the price of filet mignon drops? No, we rejoice. Who wouldn't want to buy the highest-quality steaks at chopped meat prices?"
At the end of June 2008, cash represented just over 11 percent of Buffett's balance sheet. He used some of it to provide high-cost financing for then top-credit-rated companies Goldman Sachs and GE, both desperately in need of cash. He announced his biggest acquisition to date - buying the Burlington Northern Santa Fe Railway for $34 billion. At $100 a share, he paid a reasonable, but not a cheap, price.
Most CEOs, however, focus on growth in corporate profits more than on cash and balance sheet growth. The source of the problem is: some of the reported expenses in these income statements are cash, and some are determined by accounting rules. As a result, earnings include both cash and noncash (i.e., "accounting") numbers. Buffett cares most about the cash part.
Cash is real. Noncash earnings are subject to accounting interpretations. They can be adjusted to inflate earnings and boost the stock price. But it is harder to fiddle with the cash numbers.
Buffett's long-term cash obsession creates unique opportunities that others miss. Buffett keeps a lot of cash on hand in order to be ready for unique crisis-born opportunities. "Do we panic when the price of filet mignon drops? No, we rejoice. Who wouldn't want to buy the highest-quality steaks at chopped meat prices?"
At the end of June 2008, cash represented just over 11 percent of Buffett's balance sheet. He used some of it to provide high-cost financing for then top-credit-rated companies Goldman Sachs and GE, both desperately in need of cash. He announced his biggest acquisition to date - buying the Burlington Northern Santa Fe Railway for $34 billion. At $100 a share, he paid a reasonable, but not a cheap, price.
Why Buffett decides not to pay out dividends in 45 years in Berkshire Hathaway?
He has been able to reinvest Berkshire's profits at rates considerably higher than Berkshire's investors could have earned y reinvesting them in the market.
When the company can no longer meet the test of reinvesting $1.00 of EPS to create $1 of additional value, then, says Buffett, Berkshire will pay dividends, and let his owner-partners reinvest the cash.
When the company can no longer meet the test of reinvesting $1.00 of EPS to create $1 of additional value, then, says Buffett, Berkshire will pay dividends, and let his owner-partners reinvest the cash.
Ask yourself this ONE question, every time a stock price goes up or down.
Every time a stock goes up or down, you should ask yourself:
Is this price movement based on changing fundamental or changing sentiment?
Sometimes the answer is not so obvious.
In such a situation, here is a good guiding principle.
It is better to be approximately right than to be exactly wrong.
Is this price movement based on changing fundamental or changing sentiment?
Sometimes the answer is not so obvious.
In such a situation, here is a good guiding principle.
It is better to be approximately right than to be exactly wrong.
Thursday 9 October 2014
Essentials of Value Investing
The Intelligent Investor by Benjamin Graham and Greenwald’s Book: Value Investing from Graham to Buffett and Beyond.
Class Case Studies
This is a class in a specific kind of investing. There are two basic approaches. There are short-term investors (preferably not investing taxable money). Many technical investors who do not care about the underlying quality of the companies invest solely on price information. Although some value investors build a time element into their investments. There are investors who look at short-term earnings. Analysts spend their time on earnings’ forecasting. If you think IBM is going to do $1.44 vs. the analyst estimates of $1.40, then you buy IBM, because analysts are behind the real growth in earnings. Your estimate is correct.
Another group, who has given up altogether, they believe the markets are efficient; they index. Unless the distribution is very skewed, then only 50% of the investors can outperform the market. This is a market for long-term investors with a particular orientation (value investors). You look at a security and it will represent a claim on earnings and assets. What is that claim worth? If you think that a company is worth $22 to $24 per share, then you look to buy with a margin of safety. When the margin of safety is sufficiently large, you will buy. You will look for bargains.
Value Investors constitute only 7% of the investor universe. There is substantial statistical evidence that value investing works: higher returns with lower risks than the market.
Value Investing (“VI”) rests on three key characteristics of financial markets:
1. Prices are subject to significant and capricious movements that can temporarily cause price to diverge from intrinsic value. Mr. Market is to offer you various prices, not to guide you. Emotionalism and short-term thinking rule market prices in the short-run.
2. Financial assets do have underlying or fundamental economic values that are relatively stable and can be measured by a diligent and disciplined investor. Price and value often diverge.
3. A strategy of buying when prices are 33% to 50% below the calculated intrinsic value will produce superior returns in the long-run. The size of the gap between price and value is the "margin of safety
We put someone (into business with a value formula that has averaged 20% plus returns over the past four years. He will be on the show, Imposter!
The preponderance of evidence is overwhelming for value investing as a good approach.
1. Statistical evidence
2. Performance evidence of big value funds (Oakmark, Third Avenue, Fairholme, Tweedy Browne)
3. Relatively episodic evidence that a disproportionately large amount or percentage of successful investors follow the value approach.
All human beings have certain predispositions that hurt themselves and prevent them from following
the value approach.
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.
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