Value Investing Principles

McDonough School of Business

Economics of Strategic Behavior

Professor Arthur Dong

Value Investing
Founding Fathers of Value Investing were professors Benjamin Graham and David Dodd of the Columbia Business School The Bibles
The Intelligent Investor Securities Analysis

The disciples are

Warren Buffett Mario Gabelli Walter Schloss

Value Investing

Value Investing
Involves the application of strategic analysis to finance Rely on what is knowable not on the unknown Its all about picking your races and picking your horses

Value Investing Process

Search
Cheap Ugly Obscure Ignored

Valuation
Assets Earnings Power Value Franchise

Review
Key Issues Collateral Evidence Personal Biases

Risk Management
Margin of Safety Some Diversification Patience Default Strategy

Value Investing

In the investment business everyone thinks they have an edge It is well established that the cheap / ugly / obscure actually outperform the market over long periods of timeWarren Buffett Low Market to Book Value = Outperformance Small and cheap stocks outperform Avoid the expensive: want to buy boring and cheap

Systemic Biases
Institutional Biases
Herd Mentality to minimize deviations Window dressing money managers The constant hunt for blockbusters Next Big Thing

Individual Biases
Loss Aversion Hindsight Bias Lottery ticket mentality Buying the dream and getting rich quick People shy away from the ugly to a high degree People have more confidence in their judgment than justified Hindsight not adjusted very much People have an exaggerated sense of good news

Behavioral Finance
On the institution side, fund managers have a tendency to mimic and copy one another The astute investor can take advantage of institutional and individual biases and tendencies to their own benefit To be a good investor, you have to be good at estimating value

Traditional Approaches
Traditional MBA Corporate Finance and DCF Model
Estimate cash flows over five years or more (expected cash flows) Estimate the cost of capital for the firm Adopt a terminal growth rate Estimate terminal cost of capital Add it all back to derive value

Problem: This method is highly loaded toward the terminal value

Traditional Approach

Big Assumption If you knew for sure the cash flows and the cost of capital into the distant future, then the DCF model will work But if you dont know.then this may not be the wisest approach

DCF Limitations

DCF takes good information and combines it with bad information to predict the future
Add it all together and you get bad information

(+) + (-) = (-)

DCF Limitations

With the multiples or DCF method you are making big assumptions about the future. Plug in your numbers, turn the crank and spit out a value for the company. The assumptions are almost always arbitrary

Differing Approaches

Traditional Approach Questions: Profit Rate 6% Economically viable? Cost of Capital 10% Investment / Sales 60% Profit Rate 9% Growth Rate 7%

Strategic Approach Questions: Is the industry economically viable? Are there any competitive advantages? Is there free entry? Does the Firm enjoy a sustainable competitive advantage? If the competitive advantage is stable the firm grows with the industry

The World According to Warren Buffett

Know what you know, rely on your circle of competence Start off with the most reliable information and work toward the least reliable making adjustments along the way Organize value components by underlying strategic assumptions from no competitive advantage to growing competitive advantage

The Scriptures According to Benjamin Graham

Starts with information that is normally discarded, the balance sheet Balance Sheet closely evaluate the tangible assets (things you can touch and see) Ask yourself is the industry viable? If it is not viable, then value the assets at liquidation value If the industry is viable, then value the assets at the reproduction cost (how much to enter the business today?) If you have inventory, what would it cost to reproduce it today? If you have a factory, what would it cost to reproduce it today?

Basic Elements of Value

Reliability Dimension

Valuing the Earnings

Next most important value component, EPV or Earnings Power Value EPV will reveal the average distributable earnings of the firmthis can be calculated

Graham, Dodd, Buffett

Two key determinants of value 1. Asset Value 2. Earnings Power Value

On Valuing Growth
The third component of value is growth For many companies, the high market price / valuations are related to future growth In general, value investors will not pay for growthprofitable growth is uncertain If growth is forecasted, there better be a moat built around that growth to protect it from potential entrants

Determining Asset Value

Asset Cash A/R Inventories PP&E Product Portfolio Customer Relationships Organization License & Franchises Subsidiaries

Value Book Book + adjustment for uncollectibles Book + LIFO adjustment Original Cost plus adjustment to renew Years R&D expense Years SG&A Present market values Private market value

Deriving Asset Value

Once you have completed valuing the assets, make sure you have correctly included the intangible assets as well (customer relationships, new product development, brand recognition) Add up the assets and subtract liabilities to come up with net asset value

Earnings Power Value

EPV = Earnings x 1 / Cost of Capital

Start with operating earnings (EBIT) Take earnings and subtract one time charges Multiply average margins by sustainable revenues to derive normalized EBIT Multiply by the average tax rate Add-back depreciation

This will yield normalized earnings

EPV

EPV Business Operations = earnings power x 1 / WACC

EPV Company = EPV Business Operations + excess net assets (cash, real estate legacy costs)

EPV and the Value of Assets

Valuation Asset Value > EPV What it means Value is lost due to poor management and or industry decline. Look at the proxy statement to change management. Indicates company is playing on a level playing field. Free entry without substantial barriers allow entrants. Consequence of competitive advantage and or superior management. Powerful, sustainable competitive advantage in place. Coke has 10bb in assets, 60bb in EPV there is a 60bb moat built around its franchise

Asset Value = EPV

Asset Value < EPV

Value of Growth
When looking at GrowthProceed with extreme caution This is the least reliable value indicator and it is highly sensitive to assumptions Ask: does the growth have any value at all? In practice, growth requires additional investment The more investment, the less distributable cash flow The key when evaluating growth is the existence of barriers to entry and competitive advantage Growth with no barriers = No Value to Growth

Growth Dilemma
Crappy management is on a mission to grow growth will kill you because it wastes valuable resources Competitive markets: no barriers, investment will lead to break even Growth has value if there are competitive barriers in place

Evaluating Growth in Practice

1. Verify the existence of a franchise, look at the history of returns, stability of returns, any sustainable competitive advantage 2. Calculate earnings 3. Identify cash distribution portion of earnings (dividend and repurchases) 4. Identify organic (low investment) growth GDP + / 5. Identify reinvestment return (multiple of percentage of retained earnings) 6. Compare to market returns 7. Identify Options positive or negative