Conventional Valuation Yardsticks: Earnings and Earnings Growth

Earnings and Earnings Growth

Earnings per share has historically been the valuation yardstick most commonly used by investors.

Unfortunately, as we shall see, it is an imprecise measure, subject to manipulation and accounting vagaries.

It does not attempt to measure the cash generated or used by a business.

And as with any prediction of the future, earnings are nearly impossible to forecast.


Massaging earnings by managements

Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend.

A few particularly unscrupulous managements play accounting games to turn

• deteriorating results into improving ones, 
• losses into profits, and 
• small profits into large ones.

Earnings can mislead as to the real profit.

Even without manipulation, analysis of reported earnings can mislead investors as to the real profitability of a business.

Generally accepted accounting practices (GAAP) may require actions that do not reflect business reality.

• By way of example, amortization of goodwill, a noncash charge required under GAAP, can artificially depress reported earnings; an analysis of cash flow would better capture the true economics of a business. 
• By contrast, nonrecurring gains can boost earnings to unsustainable levels, and should be ignored by investors." 

Most important, whether investors use earnings or cash flow in their valuation analysis, it is important to remember that the numbers are not an end in themselves. Rather they are a means to understanding what is really happening in a company.




Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield

Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

Business valuation is a complex process yielding imprecise and uncertain results.

1.   Many businesses simply cannot be valued intelligently.

Many businesses are so diverse or difficult to understand that they simply cannot be valued.

Some investors willingly voyage into the unknown and buy into such businesses, impatient with the discipline required by value investing.


2.   Wait for the right pitch to swing

Investors must remember that they need not swing at every pitch to do well over time; indeed, selectivity undoubtedly improves an investor's results. 


3.   Stay within your Circle of Competence

For every business that cannot be valued, there are many others that can. 

Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else.

Choosing Among Valuation Methods

How should investors choose among the several valuation methods? 

When is one clearly preferable to the others? 

When one method yields very different values from the others, which should be trusted?

At times, a particular method may stand out as the most appropriate. 



Valuation Methods

1.   Net Present Value, NPV
Net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low.

Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis.


2.   Liquidation Value
Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value.  


3.   Stock Market Value
A closed-end fund or other company that owns only marketable securities should be valued by the stock market method; no other makes sense.


4.   Several methods to value a complex business
Often, several valuation methods should be employed simultaneously.  To value a complex entity such as a conglomerate operating several distinct businesses for example,  some portion of the assets might be best valued using one method and the rest with another. 


5.   Several methods to value a single business to obtain a range of values.
Frequently investors will want to use several methods to value a single business in order to obtain a range of values.  In this case, investors should err on the side of conservatism, adopting lower values over higher ones unless there is strong reason to do otherwise.  True, conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizable losses that would ensue from adopting less conservative business valuations.

Avoidance of loss is the surest way to ensure a profitable outcome.

Be fearful when others are greedy

It can be hard to concentrate on potential losses

• while others are greedily reaching for gains and 
• your broker is on the phone offering shares in the latest "hot" initial public offering. 

Yet the avoidance of loss is the surest way to ensure a profitable outcome.




Stocks do outperform bonds and cash over the years

A loss-avoidance strategy is at odds with recent conventional market wisdom.  Today, many people believe that risk comes, not from owning stocks, but from not owning them.   

• Stocks as a group, this line of thinking goes, will outperform bonds or cash equivalents over time, just as they have in the past.
• Indexing is one manifestation of this view.  
• The tendency of most institutional investors to be fully invested at all times is another.

There is an element of truth to this notion; stocks do figure to outperform bonds and cash over the years. 



Equities are inherently riskier than debt instruments

Being junior in a company's capital structure and lacking contractual cash flows and maturity dates, equities are inherently riskier than debt instruments.

• In a corporate liquidation, for example, the equity only receives the residual after all liabilities are satisfied.  
• To persuade investors to venture into equities rather than safer debt instruments, they must be enticed by the prospect of higher returns.   
• However, the actual risk of a particular investment cannot be determined from historical data.  It depends on the price paid. 
• If enough investors believe the argument that equities will offer the best long-term returns, they may pour money into stocks, bidding prices up to levels at which they no longer offer the superior returns.  
• The risk of loss stemming from equity's place in the capital structure is exacerbated by paying a higher price.

Risk avoidance is the single most important element of an investment program

Another common belief is that risk avoidance is incompatible with investment success. This view holds that high return is attainable only by incurring high risk and that long-term investment success is attainable only by seeking out and bearing, rather than avoiding, risk.

Why do I believe, conversely, that risk avoidance is the single most important element of an investment program?

• If you had $1,000, would you be willing to wager it, double or nothing, on a fair coin toss?  Probably not.
• Would you risk your entire net worth on such a gamble?  Of course not.
• Would you risk the loss of, say, 30% of your net worth for an equivalent gain"  Not many people would because the loss of a substantial amount of money could impair their standard of living while a comparable gain might not improve it commensurately. 

Conclusion:

If you are one of the vast majority of investors who are risk averse, then loss avoidance must be the cornerstone of your investment philosophy.

"Don't lose money." Avoiding loss should be the primary goal of every investor.

Warren Buffett likes to say that the first rule of investing is "Don't lose money," and the second rule is, "Never forget the first rule."

Avoiding loss should be the primary goal of every investor.

This does not mean that investors should never incur the risk of any loss at all.

Rather "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of principal.


Avoidance of loss is the surest way to ensure a profitable outcome.

Why should the history of the junk-bond market in the 1980s interest investors today?

The junk-bonds market collapsed in 1990.

• Junk bonds were transformed into the financial equivalent of roach motels; investors could get in , but they couldn't get out.  
• Bullish assumptions were replaced by bearish ones.  
• Investor focus shifted from what might go right to what could go wrong, and prices plummeted.

Why should the history of the junk-bond market in the 1980s interest investors today?

If you personally avoided investing in newly issued junk bonds, what difference should it make to you if other investors lost money?

The answer is that junk bonds had a pernicious effect on other sectors of the financial markets and on the behaviour of most financial-market participants.

• The overpricing of junk bonds allowed many takeovers to take place at inflated valuations.
• The excess profits enjoyed by the shareholders of the acquired companies were about equal to the losses eventually experienced by the buyers of this junk.
• Cash received by equity investors from junk-bond-financed acquisitions returned to the stock market, bidding up the prices of shares in still independent companies. 
• The market prices of securities involved in arbitrage transactions, exchange offers, and corporate reorganizations were all influenced by the excessive valuations made possible by the junk-bond market.  
• As a result, even those who avoided owning junk bonds found it difficult to escape their influence completely.

We may confidently expect that there will be new investment fads in the future.  

• They too will expand beyond the rational limitations of the innovation. 
• As surely as this will happen, it is equally certain that no bells will toll to announce the excess.  
• Investors who study the junk-bond debacle may be able to identify these new fads for what they are and avoid them.  
• And avoiding losses is the most important prerequisite to investment success.

EBITDA Analysis Obscures the Difference between Good and Bad Businesses

EBITDA, in addition to being a flawed measure of cash flow, also masks the relative importance of the several components of corporate cash flow.

Pretax earnings and depreciation allowance comprise a company's pretax cash flow; earnings are the return on the capital invested in a business, while depreciation is essentially a return of the capital invested in a business.


Service Company X
(millions)
Revenue $100
Cash Expenses  80
Depreciation and Amortization 0
___________________________
EBIT  $20
___________________________
EBITDA $20



Manufacturing Company Y
(millions)
Revenue $100
Cash Expenses  80
Depreciation and Amortization 20
____________________________
EBIT  $0
____________________________
EBITDA $20



Investors relying on EBITDA as their only analytical tool would value these two businesses equally.

At equal prices, however, most investors would prefer to own Company X, which earns $20 million, rather than Company Y, which earns nothing.

Although these businesses have identical EBITDA, they are clearly not equally valuable. 

• Company X could be a service business that owns no depreciable assets.   
• Company Y could be a manufacturing business in a competitive industry.

Company Y must be prepared to reinvest its depreciation allowance (or possibly more, due to inflation) in order to replace its worn-out machinery.   It has no free cash flow over time.

• Anyone who purchased Company Y on a leveraged basis would be in trouble.  
• To the extent that any of the annual $20 million in EBITDA were used to pay cash interest expense, there would be a shortage of funds for capital spending when the plant and equipment needed to be replaced. 
• Company Y would eventually go bankrupt, unable both to service its debt and maintain its business.  

Company X, by contrast, has no capital-spending requirements and thus has substantial cumulative free cash flow over time.

• Company X, by contrast, might be an attractive buyout candidate.

The shift of investor focus from after-tax earnings to EBIT and then to EBITDA masked important differences between businesses, leading to losses for many investors.

EBITDA: analytically flawed and resulted in the chronic overvaluation of businesses

Investors in public companies have historically evaluated them on reported earnings.

By contrast, private buyers of entire companies have valued them on free cash flow.



Historical

In the latter half of the 1980s, entire businesses were bought and sold almost as readily as securities, and it was not unreasonable for investors in securities to start thinking more like buyers and sellers of entire businesses.

In a radical departure from the historical norm, many stock and junk-bond buyers in the latter half of the 1980s replaced earnings with cash flow as the analytical measure of value.

In their haste to analyze free cash flow, investors in the 1980s sought a simple calculation, a single number, that would quantify a company's cash-generating ability.  The cash-flow calculation the great majority of investors settled upon was EBITDA.

Virtually all analyses of highly leveraged firms relied on EBITDA as a principal determinant of value, sometimes as the only determinant.  

Even non-leveraged firms came to be analysed in this way since virtually every company in the late 1980s was deemed a potential takeover candidate.  

Unfortunately EBITDA was analytically flawed and resulted in the chronic overvaluation of businesses.





How should cash flow be measured?

Before the junk-bond era investors looked at two components: 

• after tax earnings, (that is the profit of a business); plus 
• depreciation and amortization minus capital expenditures (that is, the net investment or disinvestment in the fixed assets of a business.)

The availability of large amounts of non-recourse financing changed things.  

Since interest expense is tax deductible, pretax, not after-tax, earnings are available to pay interest on debt; money that would have gone to pay taxes goes instead to lenders. 

A highly leveraged company thus has more available cash flow than the same business utilizing less leverage.


Notwithstanding, EBIT is not necessarily all freely available cash.

• If interest expense consumes all of EBIT, no income taxes are owed.
• If interest expense is low, however, taxes consume an appreciable portion of EBIT.

At the height of the junk-bond boom, companies could borrow an amount so great that all of EBIT (or more than all of EBIT) was frequently required for paying interest.  

In a less frothy lending environment companies cannot become so highly leveraged at will. 

• EBIT is therefore not a reasonable approximation of cash flow for them.  
• After-tax income plus that portion of EBIT going to pay interest expense is a company's true cash flow derived from the ongoing income stream.

Depreciation

Cash flow, also results from the excess of depreciation and amortization expenses over capital expenditures.  It is important to understand why this is so. 

• When a company buys a machine, it is required under GAAP to expense that machine over its useful life, a procedure known in accounting as depreciation.  
• Depreciation is a noncash expense that reduces net reported profits but not cash.  
• Depreciation allowances contribute to cash but must eventually be used to fund capital expenditures that are necessary to replace worn out plant and equipment.  
• Capital expenditures are thus a direct offset to depreciation allowances; the former is as certain a use of cash as the latter is a source.  

The timing may differ: a company may invest heavily in plant and equipment at one point and afterward generate depreciation allowances well in excess of current capital spending. 

• Whenever the plant and equipment need to be replaced, however cash must be available.  
• If capital spending is less than depreciation over a long period of time, a company is undergoing gradual liquidation.

Amortization

Amortization of goodwill is also a noncash charge but,conversely, is more of an accounting fiction than a real business expense. 

When a company is purchased for more than its tangible book value, accounting rules require the buyer to create an intangible balance-sheet asset known as goodwill to make up for the difference, and then to amortize that goodwill over forty years. 

• Amortization of goodwill is thus a charge that does not necessarily reflect a real decline in economic value and that likely need not be spent in the future to preserve the business. 
• Charges for goodwill amortization usually do represent free cash flow.

Why was EBITDA used?

It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. 

• EBIT did not accurately measure the cash flow from a company's ongoing income stream.  
• Adding back 100% of depreciation and amortization to arrive at EBITDA rendered it even less meaningful.  

Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out.  

• In fact, many leveraged takeovers of the 1980s forecast steadily rising cash flows resulting partly from anticipate sharp reductions in capital expenditures.  
• Yet the reality is that if adequate capital expenditures are not made, a corporation is extremely unlikely to enjoy a steadily increasing cash flow and will instead almost certainly face declining results.

What is the required level of capital expenditure for a given business?

It is not easy to determine the required level of capital expenditures for a given business.  Businesses invest in physical plant and equipment for many reasons: 

• to remain in business, 
• to compete, 
• to grow and 
• to diversify.  

Expenditures to stay in business and to compete are absolutely necessary. 

Capital expenditures required for growth are important but not usually essential.

Capital expenditures made for diversification are often not necessary at all.  

Identifying the necessary expenditures requires intimate knowledge of a company, information typically available only to insiders.  

Since detailed capital-spending information are not readily available to investors, perhaps they simply chose to disregard it.

EBITDA by ignoring capital expenditures is flawed

Some analysts and investors adopted the view that it was not necessary to subtract capital expenditures from EBITDA because ALL the capital expenditures of a business could be financed externally (through lease financing, equipment trusts, nonrecourse debt, etc.). 

• One hundred percent of EBITDA would thus be free pretax cash flow available to service debt; no money would be required for reinvestment int he business.  

This view was flawed, of course. 

• Leasehold improvements and parts of a machine are not typically financeable for any company.  
• Companies experiencing financial distress, moreover, will have limited access to external financing for any purpose.   
• An over-leveraged company that has spent its depreciation allowances on debt service may be unable to replace worn-out plant and equipment and eventually be forced into bankruptcy or liquidation.

EBITDA:  a clear case of circular reasoning to justify high takeover prices

EBITDA may have been used as a valuation tool because no other valuation method could have justified the high takeover prices prevalent at the time. 

This would be a clear case of circular reasoning. 

• Without high-priced takeovers there we no upfront investment banking fees, no underwriting fees on new junk-bond issues, and no management fees on junk-bond portfolios.  
• This would not be the first time on Wall Street that the means we adapted to justify an end.  
• If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance is to invent a new standard.

Reflexivity: How stock prices can influence underlying values?

The Reflexive Relationship Between Market Price and Underlying Value

A complicating factor in securities analysis is the reflexive or reciprocal relationship between security prices and the values of the underlying businesses.

In The Alchemy of Finance, George Soros stated,
"Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values."  

In other words, Soros's theory of reflexivity makes the point that its stock price can at times significantly influence the value of a business.  

Investors must not lose sight of this possibility.



Examples:

1.   Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital.  When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. 

• If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy.  The stock market says there is no problem, so there is no problem.   
• Example:  A company stock traded in the teens and the company was able to find buyers for newly issued securities.  If its stock price had been in the low single digits, however, it would have been unable to raise additional equity capital, which could have resulted in its eventual failure.  
• This is another, albeit negative form of self-fulfilling prophecy, whereby the financial markets' perception of the viability of a business influences the outcome.

2.   Another form of reflexivity exists when the managers of a business accept its securities' prices, rather than business fundamentals, as the determining factor in valuation.  

• If the management of a company with an undervalued stock believes that the depressed market price is an accurate reflection of value, they may take actions that prove the market right.  
• Stock could be issued in a secondary offering or merger, for example, at a price so low that it significantly dilutes the value of existing shares.

3.   As another example of reflexivity, the success of a reorganization plan for a bankrupt company may depend on certain values being realized by creditors. 

• If the financial markets are depressed at the time of reorganization, it could be difficult, perhaps impossible, to generate agreed values for creditors if those values depend on the estimated market prices of debt and equity securities in the reorganized company.  
• In circular fashion, this could serve to depress even further the prices of securities in this bankrupt company.

4.   The same holds true for a highly leveraged company with an upcoming debt maturity.  

• If the market deems a company creditworthy, the company will be able to refinance and fulfill the prophecy.  
• If the market votes thumbs down on the credit, however, that prophecy will also be fulfilled since the company will then fail to meet its obligations.

Conclusion:

Reflexivity is a minor factor in the valuation of most securities most of the time, but occasionally it becomes important. 

This phenomenon is a wild card, a valuation factor not determined by business fundamentals but rather by financial market themselves.

Risk and Return: Risk does not create incremental return, only Price can

While most other investors are preoccupied with how much money they can make and not at all with how much they may lose, value investors focus on risk as well as return.




Most investors seem confused about risk.

Some insist that risk and return are ALWAYS positively correlated, the greater the risk, the greater the return.  This is in fact, a basic tenet of the capital-asset-pricing model taught in nearly all business schools, yet it is not always true.

Others mistakenly equate risk with volatility, emphasizing the "risk" of security price fluctuations while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments.

A positive correlation between risk and return would hold consistently only in an efficient market.

• Any disparities would be immediately corrected; this is what would make the market efficient.  

In inefficient markets it is possible to find investments offering high returns with low risk.  These arise

• when information is not widely available, 
• when an investment is particularly complicated to analyze, or 
• when investors buy and sell for reasons unrelated to value.  

It is also common place to discover high risk investments offering low returns.  

• Overpriced and therefore risky investments are often available because the financial markets are biased toward overvaluation and because it is difficult for market forces to correct an overvalued condition if enough speculators persist in overpaying.  
• Also, unscrupulous operators will always make overpriced investments available to anyone willing to buy; they are not legally required to sell at a fair price.

Risk and return must be assessed independently for every investment.

Since the financial markets are inefficient a good deal of the time, investors cannot simply select a level of risk and be confident that it will be reflected in the accompanying returns.  

Risk and return must instead be assessed independently for every investment.

In point of fact, greater risk does not guarantee greater return.

• To the contrary, risk erodes return by causing losses.  
• It is only when investor shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred.  

By itself risk does not create incremental return, only price can accomplish that.  

Value Pretenders

A broad range of strategies make use of value investing as a pseudonym.  Many have little or nothing to do with the philosophy of investing originally espoused by Graham.

The long-term success of true value investors such as Buffett at Berkshire Hathaway and others, attracted a great many "value pretenders," investment chameleons who frequently change strategies in order to attract funds to manage.

• These value pretenders are not true value investors, disciplined craftspeople who understand and accept the wisdom of the value approach.  
• Rather they are charlatans who violate the conservative dictates of value investing, using inflated business valuations, overpaying for securities, and failing to achieve a margin of safety for their clients.

These investors, despite (or perhaps as a direct result of ) their imprudence, are able to achieve good investment results in times of rising markets.

• During the latter half of the 1980s, value pretenders gained widespread acceptance, earning high, even spectacular returns.  
• Many of them benefited from the overstated private-market values that were prevalent during those years; when business valuations returned to historical levels in 1990-, however, most value pretenders suffered substantial losses.

To some extent, value like beauty, is in the eye of the beholder; virtually any security may appear to be a bargain to someone.  

• It is hard to prove an overly optimistic investor wrong in the short run since value is not precisely measurable and since stocks can remain overvalued for a long time.  
• Accordingly, the buyer of virtually any security can claim to be a value investor at least for a while.

Many true value investors fell into disfavour during the late 1980s.  

• As they avoided participating in the fully valued and overvalued securities that the value pretenders claimed to be bargains, many of them temporarily underperformed the results achieved by the value pretenders.  
• The most conservative were actually criticized for their "excessive" caution, prudence that proved well founded in 1990.

Even today, many of the value pretenders have not been defrocked of their value-investor mantle.

Value Investing is Predicated on the Efficient Market Hypothesis being Wrong.

Value investing:  there is recurrent mis-pricing of securities

Investors should understand not only what value investing is but also why it is a successful investment philosophy.

At the very core of its success is the recurrent mis-pricing of securities in the marketplace.  

Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong. 

• If, on the one hand, securities can become undervalued or overvalued, which I believe to be incontrovertibly true, investors will thrive.  
• If, on the other hand, all securities at some future date become fairly and efficiently priced, value investors will have nothing to do.  

It is important, then, to consider whether or not the financial markets are efficient.




The efficient market hypothesis takes three forms.  

• The weak form maintains that past stock prices provide no useful information on the future direction of stock prices.  In other words, technical analysis (analysis of past price fluctuations) cannot help investors.  
• The semi-strong form says that NO published information will help investors to select undervalued securities since the market has already discounted all publicly available information into securities prices.  
• The strong form maintains that there is no information, public or private, that would benefit investors.  

Implication of efficient market hypothesis

Of the three forms of the efficient market hypothesis, I believe that only the weak form is valid.  Technical analysis is indeed a waste of time.

As to the other forms:  yes, the market does tend to incorporate new information into prices - securities prices are neither random nor do they totally ignore available information - yet the market is far from efficient.

The implication of both the semi-strong and strong forms is that fundamental analysis is useless.  Investors might just as well select stocks at random.



Investors applying disciplined analysis can identify inefficiently priced securities and achieve superior returns while taking below-average risks.

There is simply no question that investors applying disciplined analysis can identify inefficiently priced securities, buy and sell accordingly, and achieve superior returns. 

Specifically by finding securities whose prices depart appreciably from underlying value, investors can frequently achieve above-average returns while taking below-average risks. 

The pricing of large-capitalization stocks tends to be more efficient than that of small-capitalization stocks, distressed bonds, and other less-popular investment fare.

While hundreds of investment analysts follow IBM, few, if any, cover thousands of small-capitalization stocks and obscure junk bonds.  Investors are more likely, therefore, to find inefficiently priced securities outside the Standard and Poor's 100 than within it.

Even among the most highly capitalized issues, however, investors are frequently blinded by groupthink, thereby creating pricing inefficiencies.




Efficient-market theory is at odds with the reality of how the financial markets operate.

Is it reasonable to expect that in the future some securities will continue to be significantly mispriced from time to time?

I believe it is.

The elegance of the efficient-market theory is at odds with the reality of how the financial markets operate.




Buffett's "The Superinvestors of Graham and Doddsville"

If the markets were efficient, then how could so many investors, identifiable by Buffett years ago as sharing a common philosophy but having little overlap in their portfolios, all have done so well?

Buffett's "The Superinvestors of Graham and Doddsville" demonstrates how nine value investment disciples of Benjamin Graham, holding varied and independent portfolios, achieved phenomenal investment success over long periods. 

His view is that the only thing the many value investors have in common is a philosophy that dictates the purchase of securities at a discount from underlying value.

 The existence of so many independent successes is so inconsistent with the efficient-market theory.

The Merits of Bottom-Up Investing

Top-down approach

Many professional investors employ a top-down approach.  This involves making a prediction about the future, ascertaining its investment implications, and then acting upon them.

• This approach is difficult and risky, being vulnerable to error at every step.  
• Practitioners need to accurately forecast macroeconomic conditions and then correctly interpret their impact on various sectors of the overall economy, on particular industries, and finally on specific companies. 
• It is also essential for top-down investors to perform this exercise quickly as well as accurately, or others may get there first and, through their buying or selling, cause prices to reflect the forecast macroeconomic developments, thereby eliminating the profit potential for latecomers.

By way of example, a top-down investor must be

• correct on the big picture, 
• correct in drawing conclusions from that, 
• correct in applying those conclusions to attractive areas of investment, 
• correct in the specific securities purchased and 
• finally, be early in buying these securities.

The top-down investor thus faces the daunting task of predicting the unpredictable more accurately and faster than thousands of other bright people, all of them trying to do the same thing.

• It is not clear whether top-down investing is a greater-fool game, in which you win only when someone else overpays, or a greater-genius game, winnable at best only by those few who regularly possess superior insight.  
• In either case, it is not an attractive game for risk-averse investors.

There is no margin of safety in top-down investing. 

• Top-down investors are not buying based on value; they are buying based on a concept, theme, or trend.  
• There is no definable limit to the price they should pay, since value is not part of their purchase decision.  
• It is not even clear whether top-down-oriented buyers are investors or speculators.  If they buy shares in businesses that they truly believe will do well in the future, they are investing.  If they buy what they believe others will soon be buying, they may actually be speculating.

Another difficulty with a top-down approach is gauging the level of expectations already reflected in a company's current share price. 

• If you expect a business to grow 10% a year based on your top-down forecast and buy its stock betting on that growth, you could lose money if the market price reflects investor expectations of 15% growth but a lower rate is achieved.  
• The expectations of others must therefore be considered as part of any top-down investment decision.

Bottom-up strategy

By contrast, value investing employs a bottom-up strategy by which individual investment opportunities are identified one at a time through fundamental analysis. 

Value investors search for bargains security by security, analysing each situation on its own merits.

An investor's top-down views are considered only in so far as they affect the valuation of securities.




A bottom-up strategy is in many ways simpler to implement than a top-down one.

• While a top-down investor must make several accurate predictions in a row, a bottom-up investor is not in the forecasting business at all.  
• The entire strategy can be concisely described as "buy a bargain and wait."   
• Investors must learn to assess value in order to know a bargain when they see one.  
• Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large.

Differences between Bottom-up and Top-down investors


One significant and not necessarily obvious difference between a bottom-up and top-down strategy is the reason for maintaining cash balances at times. 

• Bottom-up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when such opportunities appear.  
• A bottom-up investor chooses to be fully invested only when a diversified portfolio of attractive investments is available.
• Top-down investors, by contrast, may attempt to time the market, something bottom-up investors do not do.  
• Market timing involves making a judgment about the overall market direction; when top-down investors believe the the market will decline, they sell stocks to hold cash, awaiting a more bullish opinion.

Another difference between the two approaches is that bottom-up investors are able to identify simply and precisely what they are betting on.  The uncertainties they face are limited:

• what is the underlying business worth; 
• will that underlying value endure until shareholders can benefit from its realization; 
• what is the likelihood that the gap between price and value will narrow; and, 
• given the current market price, what is the potential risk and reward?

Bottom-up investors can easily determine when the original reason for making an investment ceases to be valid. 

A disciplined investor can reevaluate the situation and, if appropriate, sell the investment: 

• when the underlying value changes, 
• when management reveals itself to be incompetent or corrupt or 
• when the price appreciates to more fully reflect underlying business value.   

Huge sums have been lost by investors who have held on to securities after the reason for owning them is no longer valid.  

In investing it is never wrong to change your mind.  It is only wrong to change your mind and do nothing about it.

Top-down investors, by contrast, may find it difficult to know when their bet is no longer valid. 

• If you invest based on a judgement that interest rates will decline but they rise instead, how and when do you decide that you were wrong?  
• Your bet may eventually prove correct, but then again it may not.  
• Unlike judgements  about value that can easily be reaffirmed, the possible grounds for reversing an investment decision that was  made based upon a top-down prediction of the future are simply not clear.  

Three central elements to a value-investment philosophy.

There are three central elements to a value-investment philosophy.

• First, value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities.
• Second, value investing is absolute-performance, not relative-performance oriented.
• Finally, value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return).

Value investing is simple to understand but difficult to implement.

Value investors are not super-sophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value.


The hard part is

• discipline, 
• patience and 
• judgment.  

Investors need

• discipline to avoid the many unattractive pitches that are thrown, 
• patience to wait for the right pitch, and 
• judgement to know when it is time to swing.

Value Investing Shines in a Declining Market

Who's swimming naked?

When the overall market is strong, the rising tide lifts most ships.

Profitable investments are easy to come by, mistakes are not costly, and high risks seem to pay off, making them seem reasonable in retrospect.

As the saying goes, "You can't tell who's swimming naked till the tide goes out."



Torpedo stocks

A market downturn is the true test of an investment philosophy. 

Securities that have performed well in a strong market are usually those for which investors have had the highest expectations.

When these expectations are not realized, the securities, which typically have no margin of safety, can plummet.

Stocks that fit this description are sometimes referred to as "torpedo stocks," a term that describes the disastrous effect owning them. 

For example, the previous share price of a company had reflected investor expectations of high earnings growth.  When the company subsequently announced a decline in first-quarter earnings, the stock was torpedoed.



Securities owned by value investors are often unheralded or just ignored.

The securities owned by value investors are not buoyed by such high expectations.  To the contrary, they are usually unheralded or just ignored. 

In depressed financial markets, it is said, some securities are so out of favour that you cannot give them away.

Some stocks sell below net working capital per share and a few sell at less than net cash (cash on hand less all debt) per share; many stocks trade at an unusually low multiple of current earnings and cash flow and at a significant discount to book value.



A notable feature of value investing is its strong performance in periods of overall market decline. 

Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's margin of safety is high.

Stock and bond prices may anticipate continued poor business results, yet securities priced to reflect those depressed fundamentals may have little room to fall further. 

Moreover, securities priced as if nothing could go right stand to benefit from a change in perception.  

• If investors refocused on the strengths rather than on the difficulties, higher security prices would result.  
• When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them. 
• The higher multiple reflected a change in investor psychology more than any fundamental developments at the company.

What is an appropriate margin of safety?

Even among value investors, there is ongoing disagreement concerning the appropriate margin of safety.



Some highly successful investors increasingly recognize the value of intangible assets.

Some highly successful investors, including Buffett, have come increasingly to recognize the value of intangible assets - broadcast licenses or soft-drink formulas, for example - which have a history of growing in value without any investment being required to maintain them.  Virtually all cash flow generated is free cash flow.



The problem with intangible assets, is that they hold little or no margin of safety. 

The most valuable assets of Dr Pepper/Seven-Up, Inc., by way of example, are the formulas that give those soft drinks their distinctive flavours.  It is these intangible assets that cause Dr Pepper/Seven-Up, Inc., to be valued at a high multiple of tangible book value.  If something goes wrong - tastes change or a competitor makes inroads - the margin of safety is quite low.



Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss.  

Tangible assets usually have value in alternate uses, thereby providing a margin of safety.  If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, receivables collected, leases transferred, and real estate sold.  If consumers lose their taste for Dr Pepper, by contrast, tangible assets will not meaningfully cushion investors' losses.

The Importance of a Margin of Safety

Benjamin Graham has no interest in paying $1 for $1 of value; only interested in buying at a substantial discount from underlying value.

Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future.

He also understood that he might even be wrong about today's value.

Therefore Graham had no interest in paying $1 for $1 of value.  There was no advantage in doing so, and losses could result.

Graham was only interested in buying at a substantial discount from underlying value.

By investing at a discount, he knew that he was unlikely to experience losses.

The discount provided a margin of safety.



Investors need a margin of safety

Because investing is as much an art as a science, investors need a margin of safety.

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for 

• human error, 
• bad luck, or 
• extreme volatility 

in a complex, unpredictable, and rapidly changing world. 

According to Graham, "The margin of safety is always dependent on the price paid.  For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price."

Buffett described the margin of safety concept in terms of tolerances:  "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it.  And that same principle works in investing."



What is the requisite margin of safety for an investor? 

The answer can vary from one investor tot he next.

• How much bad luck are you willing and able to tolerate?  
• How much volatility in business values can you absorb?  
• What is your tolerance for error?  

It comes down to how much you can afford to lose.

Most investors do not seek a margin of safety in their holdings.

Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve a margin of safety.

Greedy individual investors who follow market trends and fads are in the same boat.

The only margin investors who purchase Wall Street under-writings or financial-market innovations usually experience is a margin of peril.  

Should investors worry about the possibility that business value may decline?

1.  Should investors worry about the possibility that business value may decline? 

Absolutely.



2.  Should they do anything about it? 

There are three responses that might be effective.

• First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.
• Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions.  This means that normally selective investors would probably let even more pitches than usual go by.
• Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value.  In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all.  If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause value to diminish become moot.

What is a relative-performance orientation?

Relative performance involves measuring investment results, not against an absolute standard, but against broad stock market indices, such as the Dow Jones Industrial Average or Standard & Poor's 500 Index, or against other investors' results.

Most institutional investors measure their success or failure in terms of relative performance.

Money managers motivated to outperform an index or a peer group of managers may lose sight of whether their investments are attractive or even sensible in an absolute sense.



Who is to blame for this short-term investment focus? 

Is it the fault of managers who believe clients want good short-term performance regardless of the level of risk or the impossibility of the task? 

Or is it the fault of clients who, in fact, do switch money managers with some frequency? 

There is ample blame for both to share.



There are NO winners in the short-term, relative-performance derby. 

Attempting to outperform the market in the short run is futile since near-term stock and bond price fluctuations are random and because an extraordinary amount of energy and talent is already being applied to that objective. 

The effort only distracts a money manager from finding and acting on sound long-term opportunities as he or she channels resources into what is essentially an unwinnable game. 

• As a result, the clients experience mediocre performance.  
• The overall economy is also deprived, as funds are allocated to short-term trading rather than long-term investments.  
• Only brokers benefit from the high level of activity.

Institutional investors should strive to achieve good absolute returns.

Institutional investment process should focus on maximizing returns under reasonable risk constraints.  

If more institutional investors strove to achieve good absolute rather than relative returns, the stock market would be less prone to overvaluation and market fads would less likely be carried to excess.  Investments would only be made when they presented a compelling opportunity and not simply to keep up with the herd.