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Value Investing

2014
Professor Fernando Diz

What is Value Investing?


One area of Fundamental Finance which
includes:
Value Investing
Distress Investing
Control Investing
Credit Analysis
Venture Capital

What is Value Investing?


Value investing involves identifying and
making passive financial commitments
in securities that are priced at large
discounts (30% or more) to what the
business would be worth in a private
transaction.

What do we need to
understand and learn to be
successful value investors?

Need to understand
We need to have a clear idea of what
investing means to us.

Need to understand
We need to understand how
businesses create value (wealth).
How do we view businesses?

Need to understand
We need to understand how value
(wealth) created by corporations can
be extracted by holders of securities.

Need to understand
We need to understand how to
appraise the value created by
businesses.

Need to understand
We need to understand if there are
relationships between security prices
and corporate values (if any) (i.e.
understand what market efficiency
depends on, and whether efficiency is
prevalent or not and why)

How we shall use the word


Investing
Investing as opposed to speculating
We seek a precise definition of investing as
opposed to speculation. WHY?
Failure to recognize the difference has led (in the USA)
to the financial calamities of 1929, 1987, 1989,
2008-09, and many people actually losing a lot of
wealth. Example: AAA rated RMBSs?
More simply: if you do not know what you are doing you
will get screwed.
Academic guidance on this subject has been nonexistent and what exists has largely contributed to the
existing confusion about these two terms.

WHAT do we get from a definition


of investing?
An objective benchmark with which to
contrast other financial operations.
A checklist on what to look for and what to
avoid.

HOW do we get to a
definition?
We all have some idea of what the differences
between investing and speculating are.
You will be surprised to realize how misleading
those ideas can be.
We shall explore a few of the misconceptions and
by thinking about them, we shall refine our own
definition.

1. Bonds vs. Common Stocks


What do you think, investment or
speculation?
It used to be that Bonds were considered
securities for investment purposes and
common stocks for speculative purposes.

1. Bonds vs. Common Stocks


The distinction seems to be focused on safety of
principal.
There is nothing inherently safer in credit securities in
general. Credit securities issued by poorly capitalized
companies may be very speculative in that they can
permanently lose value. Example: below investment
grade debentures.
In fact, Graham & Dodd suggested the purchases of
credit instruments that had enough cash flow support and
higher yields as an investment operation! What do you
think?

1. Bonds vs. Common Stocks


The collateral securing a bond may lose value very
rapidly. Example: Lehman Brothers. Term Fallen
Angels and Michael Milkens assertion.
Also, there is nothing inherently riskier in common
stocks. When the common stocks are issued by very
well capitalized companies the common stock can
be extremely safe.

1. Bonds vs. Common Stocks


NOTHING INHERENT TO THE FINANCIAL
INSTRUMENT OR SECURITY THAT MAKES IT
EITHER AN INVESTMENT OR A SPECULATION.
ANALYSIS OF THE SPECIFIC CASE WILL HELP
DETERMINE HOW SAFE OR NOT SAFE ANY
SECURITY OR CREDIT INSTRUMENT IS.

Credit Instruments vs.


Common Stock
WHAT IS INHERENT TO A SECURITY ARE THE
RIGHTS THAT THEY GIVE TO THEIR HOLDERS
NOT WHETHER THEY ARE SAFE OR NOT.
THIS IS WHAT YOU MUST UNDERSTAND.

2. Outright vs. margin purchases


3. For permanent holding or a quick turn
The difference is between buying with or
without using leverage and/or holding for long
periods or short periods.
Buying stock outright does not ipso facto make
it an investment.
Buying something on margin does not
necessarily make it a speculation either.

Arbitrage on margin
Example:
Borrow $155,000 for a year at 5%.
Use the proceeds of the loan to buy 100 ounces
of gold in the cash market for $1,550/oz.
Simultaneously enter into a forward agreement to
deliver gold in a year and get paid $1750/oz.

Arbitrage on margin
In one year, you deliver 100oz of gold and get
paid $175,000.
With the proceeds, you pay back the loan for
$155,000 plus the 5% interest for a total
payment of $162,750.
You make a profit of $12,250 without any risk
of loss. Really?

Real world risks


If the price of gold one year from now goes to
$1,000/oz your counter-party may want to renege on
his obligation of paying $1,750/oz.
Ways of handling this risk?
Dealing with credit worthy counter-parties that have the
intention to pay.
Requiring escrow deposits for the amount owed.
Requiring liens or pledges of collateral on property.

If the price of gold one year from now goes to


$3,000/oz you may want to get out of your
obligation.

Arbitrage on margin
This is an example where a profit is guaranteed on a
transaction that has no risk of loss and was done
entirely with borrowed money.
Moreover, it is done as a short term transaction.
Would you consider this a speculation?
NO.

4. Income vs. Profit


Back in 1929, the typical investor was interested
above all in safety of principal and the continuance
of adequate income.
Since then the doctrine has shifted the emphasis
from current income (dividends, coupons) to future
income in the form of future enhancement of
principal or capital appreciation. (common stocks
that pay no dividends, for example)

4. Income vs. Profit


Graham and Dodd on the new era style of
investment (back in 1934):
In its complete subordination of the income
element to the desire for profit, and also the
prime reliance it places upon favorable
developments expected in the future, the newera style of investment is practically
indistinguishable from speculation.

4. Income vs. Profit


Notice the paradox:
On the one hand, placing a large weight on favorable
developments expected in the future sounds highly
speculative.
However, can you dismiss the purchases of common
stocks of companies that distribute little but accumulate
surplus necessarily as a speculation?
Retained earnings may be the cheapest financing source
(on a cash basis) that will support good things like high
rates of growth, etc.

5. Safety vs. Risk of loss


Most people will immediately recognize this
distinction as the difference between an investment
and a speculation.
However, how do you evaluate safety?
There is a lot of room for what is indefinite and
subjective in the evaluation of safety. i.e. A gambler
betting on a sure thing is convinced that his
commitment is safe.

5. Standards of Safety
The concept of safety can only be of any use if it
is based on something more tangible than the
psychology of the purchaser.
Safety must be assured or at least strongly
indicated by the application of definite and well
established safety standards.
Let us look at what we mean next:

5. Standards of Safety
What are the standards of safety that we use?
Standards of safety related to the issuer (company),
i.e. strong financial position, shareholder friendly
managements, etc. These are used to insure that the
business is safe.
Standards of safety related to the issue (terms of the
issue), i.e. a secured loan is over-secured with
pledged assets of high quality. These have to do with
the substantive characteristics of securities.
Price of the issue.

What have we covered?

Summary
There is nothing inherent to a security that makes it
either an investment or a speculation.
Whether a security is purchased outright or on margin
has nothing to do with whether the operation is an
investment or a speculation.
The holding period, whether long or short, does not
necessarily discriminates between an investment or a
speculation.
Whether the security is purchased for income or profit
may not be related to whether it is an investment or a
speculation.
Safety of principal in the form of very low or nonexistent investment risk is a factor in determining
whether the commitment is an investment or a
speculation.

Definition of Investment
An investment operation is one which, upon
thorough analysis, that can be justified on both
quantitative and qualitative grounds, promises
safety of principal and a satisfactory return.
Operations that do not meet these criteria are
speculative.

Components of the definition

Investment operation rather


than an issue or purchase
Investment character does not inhere in a
security per se.
We are interested in what people do,
interested in whether a financial operation is
investing or speculation.

Thorough analysis
Means the study of the facts qualitative and
quantitative- in light of:
Established standards of safety
For issuer:(reserves, capital adequacy, strong financial
position, claim paying ability, quality of resources).
For issue: price of a security, terms, rights given, covenants.

Established standards of value


security price at a discount of ascertainable asset net asset
value [NAV], workout values in Chapter 11

Satisfactory return
A broader expression than adequate income since it
allows for capital appreciation.
It refers to total return

Conventional wisdom on risk


and return
A general notion has developed that those who
cannot afford to take risks should be content with
a low return on their invested funds. (by the way,
this is nonsense).
Academic finance has further mislead the public
with Modern Portfolio Theorys statement that the
rate of return that an investor should expect from
their invested funds is more or less proportional
to the risk (market risk) they are ready to
assume.

Example
In 1934, GE special preferred, paid 6% interest
on a $10 par and was callable on any dividend
date at $11. Calendar quarters, dividend
payment on the first week after the end of
quarter.
On December 1934, the preferred sold at $12
.
Is buying this preferred in December 1934 an
investment or a speculation and why?

Example continued
An investment operation is one which, upon
thorough analysis that can be justified on both
quantitative and qualitative grounds, promises safety
of principal and a satisfactory return. Operations that
do not meet these criteria are speculative.
Is buying the preferred a safe choice?

Example continued
Is the issuer safe?
Yes

Are the terms of the issue safe?


Yes

Is the price of the issue safe?


No

Example continued
As far as the safety of principal is concerned,
the buyer at $12 was speculating to the
extent of $1 or 10% of his principal.
He was betting that the issue would not be
called for years to come.
In fact the issue was called at $11 on April 5,
1935.

Example 2
After the call announcement was made in
January 1935, the preferred promptly traded
down to $11.
The actual call took place in April 1935, i.e.
three months hence.
Margin borrowing costs were 2% per year.
Investment opportunity for margin-buying.

Example 2 continued
Borrow $110,000 at 2% per year.
Buy 10,000 shares of preferred at $11 per share.
Collect one dividend of 6%/4= 1.5% or
0.015*100,000= $1,500 in April 1935.
Pay 2%/4 = 0.5% on $110,000 or $550
Pocket sure profit of $950 in three months.

What have we learned?


We need to have a clear idea of what we mean by
investing as opposed to speculation.
We need to understand how businesses create
values (wealth).
We need to understand how to appraise the values
created by businesses.
We need to understand how value created by
corporations can be extracted by holders of
securities.
We need to understand if there are relationships
between security prices and corporate values (if any)
(i.e. understand what market efficiency depends on,
and whether efficiency is prevalent or not and why)