It is the best book on Value investing I have seen. I did not like that different profiles for different investors not similarly structured. Some investment cases presentation is helpful, but sometimes dominated too much. Quotes: Most investors want to buy securities whose true worth is not reflected in the current market price of the shares. There is general agreement that the value of a company is the sum of the cash flows it will produce for investors over the life of the company, discounted back to the present. In many cases, however, this approach depends on estimating cash flows far into the future, well beyond the horizon of even the most prophetic analyst. Value investors since Graham have always preferred a bird in the hand-cash in the bank or some close equivalent-to the rosiest projection of future riches. Therefore, instead of relying on techniques that must make assumptions about events and conditions far into the future, value investors prefer to estimate the intrinsic value of a company by looking first at the assets and then at the current earnings power of a company. A further advantage of the value investor's approach-first the assets, then the current earnings power, and finally and rarely the value of the potential growth-is that it gives the most authority to the elements of valuation that are most credible. 2 Searching for Value: Fish Where the Fish Are The situation becomes most extreme toward the end of a reporting period, when managers window-dress their portfolios, dumping the stocks that have fallen in price and loading up on the past year's (or quarter's) successes. This pruning has the effect of driving up the price of currently successful stocks and depressing even further stocks that are already downtrodden. The end of the year has historically been a good month to pick up the value stocks that window-dressing managers have tossed out in order to avoid listing them in the year-end report. A more thorough examination of the correlation of past performance with future return would reveal just the opposite: over a two-or three-year period, yesterday's laggards become tomorrow's leaders. 3 Valuation in Principle, Valuation in Practice Three-Element Approach to Valuation: Assets, Earnings Power, and Profitable Growth The second most reliable measure of a firm's intrinsic value is the second calculation made by Graham and Dodd, namely, the value of its current earnings, properly adjusted. The traditional Graham and Dodd earnings assumptions are Using these assumptions, the equation for the earnings power value The adjustments to earnings, which we discuss in greater detail in Chapter 5, include The goal is to arrive at an accurate estimate of the current distributable cash flow of the company by starting with earnings data and refining them. To repeat, we assume that this level of cash flow can be sustained and that it is not growing. Although the resulting earnings power value is somewhat less reliable than the pure asset-based valuation, it is considerably more certain than a full-blown present value calculation that assumes a rate of growth and a cost of capital many years in the future. And while the equation for EPV looks like other multiple-based valuations we just criticized, it has the advantage of being based entirely on currently available information and is uncontaminated by more uncertain conjectures about the future. We have ignored here the value of the future growth of earnings. But we are justified in paying no attention to it because in evaluating companies operating on a level playing field, with no competitive advantages or barriers to entry, growth has no value.
It is a good review book, which put together all the different concepts together (margin of safety, intrinsic value, etc). It also has a satisfactory review of the key value investors, and you can judge for yourself that they might have quite different approaches within the value investing theme.
(1) that current earnings, properly adjusted, correspond to sustainable levels of distributable cash flow; and
(2) that this earnings level remains constant for the indefinite future.
(EPV) of a company is EPV = Adjusted Earnings x 1/R, where R is the current cost of capital. Because the cash flow is assumed to be constant, the growth rate G is zero.
1. Rectifying accounting misrepresentations, such as frequent "onetime" charges that are supposedly unconnected to normal operations; the adjustment consists of finding the average ratio that these charges bear to reported earnings before adjustments, annually, and reducing the current year's reported earnings before adjustment proportionally.
2. Resolving discrepancies between depreciation and amortization, as reported by the accountants, and the actual amount of reinvestment the company needs to make in order to restore a firm's assets at the end of the year to their level at the start of the year; the adjustment adds or subtracts this difference.
3. Taking into account the current position in the business cycle and other transient effects; the adjustment reduces earnings reported at the peak of the cycle and raises them if the firm is currently in a cyclical trough.
4. Considering other modifications we discuss in Chapter 5.
Element 3: The Value of Growth
When does growth contribute to intrinsic value? We have isolated the growth issue for two reasons. First, this third and last element of value is the most difficult to estimate, especially if we are trying to project it for a long period into the future.
4 Valuing the Assets: From Book Value to Reproduction Costs
The surest method for assigning a value to the license or franchise is to see what similar rights have sold for in the private market, that is, to a knowledgeable buyer who is paying for the whole business.
There are ways to compare situations that initially look dissimilar. There is almost always a "per" number: price per subscriber, per regional population, per caseload, per stadium seat. Recent sales in the private market provide a benchmark for valuing the license or franchise of the company under analysis.
5 Earnings Power Value: Assets Plus Franchise
Franchise only exists where a firm benefits from barriers to entry that keep out potential competitors or insure that if they choose to enter, they will operate at a competitive disadvantage relative to the incumbents. The competitive advantages that the incumbents enjoy need to be identifiable and structural. Good management is certainly an advantage, but there is nothing built in to the competitive situation to guarantee that one company's superiority on the talent count will endure over time. Structural competitive advantages come in only a few forms: exclusive governmental licenses, consumer (demand) preferences, a cost (supply) position based on long-lived patents or other durable superiorities, and the combination of economies of scale thanks to a leading share in the relevant market with consumer preference.
Spotting franchises is a difficult skill-one that takes time and work to master.
They will buy growth only at a discount from its estimated value large enough to make up for the greater uncertainty in valuation. The ideal price is zero: Pay in full for the current assets or earnings power and get the growth for free.
Equation for the present value of a growing firm, which is where F is the growth factor.
Appendix: Valuation Algebra: Return on Capital, Cost of Capital, and Growth
Whenever cash flows increase at a constant rate, it is possible to calculate the present value (PV) of this stream with the following formula: where R is the cost of capital and G is the rate of growth. If the cost of capital is 20 percent, then for zero growth the equation is The equation for the growing company is
M = PV/EPV, with M defined as the growth-related value multiplier. In this expression,
PV= CF x (ROIC-G)/(R-G)
EPV= CF x ROIC/R
8 Constructing the Portfolio: Risk, Diversification, and Default Strategies
Margin of safety requirement provides a mechanism for reducing risk that is totally distinct from diversification. Buying a company for substantially less than tangible book value or the well-tested value of its earnings is already a low-risk strategy. Using a valuation based on assets as a check on a valuation based on earnings power, all the while refusing to pay much if anything for the prospects of growth, further limits risk. If an ordinary portfolio (one not selected on value grounds) needs 20 or 30 names to be adequately diversified, then perhaps the margin of safety portfolio needs only 10 or 15.
Value investors also control risk by continually challenging their own judgments. Since many of their decisions run against the grain of prevailing Wall Street sentiment, they look for some credible confirmation of their opinions. For example, if knowledgeable insiders are buying the securities even as the market ignores the stock, the investor gains a measure of assurance.
second confirmation comes from discovering that other highly respected investors are taking similar positions.
Position limits are an additional safeguard. Investors establish policies that limit the amount of the portfolio they will commit to a single security. They can have one limit for the initial purchase and another standard for securities within the portfolio. If a position appreciates above those limits, it is a signal to trim back by selling into strength. This is certainly a form of diversification, but it is designed more to limit the exposure to any particular investment than to mimic the behavior of the broad market.
9 Warren Buffett: Investing Is Allocating Capital
Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.
The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.
Though the mathematical calculations required to evaluate equities are not difficult, an analyst-even one who is experienced and intelligent-can easily go wrong in estimating future "coupons." At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.
Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying.
Risk is "the possibility of loss or injury."
The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.
11 Glenn Greenberg: Investigate, Concentrate, and-Watch That Basket
Chieftain partners will not begin to buy a stock unless they are willing to put at least 5 per cent of their assets into it. This is an antidiversification device, and it has a manifold influence on their entire investment process. First, they need to have two types of confidence in the selection: confidence in their ability to understand the company, its industry, and its business prospects; and confidence in the company, that it will continue to perform well and increase the wealth of its shareholders.
Chieftain portfolio has far fewer than the 20 names that a strict 5 percent rule might imply. The partners normally hold 8 to 10 stocks in their accounts, and they are willing to invest heavily in a situation that they are thoroughly convinced will work out for them. To improve their odds, all four professionals in the firm study the same stocks, and they have to agree before they buy a share. If diversification is a substitute for knowledge, then information and understanding should work in reverse.
Chieftain Capital manages $3 billion for its clients. If it normally holds shares in 10 or even fewer companies, then on average it needs to put hundreds of millions into any one name. Because great situations are so difficult to find, they are prepared to buy 20 percent or more of any one company. While there are around 1,500 or more companies large enough for them to own, their "good business" requirement probably shrinks that list by 80 percent, leaving them with no more than 300 possible
Chieftain is not attracted to turnaround companies or cyclicals, where a successful investment depends on timing. He does not believe in speculating that an underperforming company will be taken over, because most managements resist selling out.
Before the arrival of the personal computer and the electronic spreadsheet, he and his partner would analyze a company by isolating its business segments and projecting revenue and expenses no more than two or three years into the future. By assuming that it would grow steadily from then on, they could calculate its current value by discounting that cash flow back to the present, using only a hand calculator. Now, with spreadsheets, they can make their projections more detailed and carry them forward further in time. Discounted cash flow analysis, a method about which we expressed some reservations in the first part of this book, is Greenberg's valuation technique of choice for all the investments he makes.
He is only interested in companies with stable earnings and relatively predictable cash flows.
And he is careful to make sure that all of the assumptions that are built into a present value analysis are reasonable and conservative: sales growth rates; profit margins; the market prices of assets such as oil, gas, and other fuels; capital expenditure requirements; and discount rates. Common sense serves as the touchstone against which all spreadsheet projections are assessed. He uses the model; he doesn't let it control him.
The real value of doing all the work required for a full discounted cash flow analysis is that it forces the investor to think long and hard about all the factors that will affect the future of the business, including the risks it may face that are currently unexpected and unforeseen.
With few stocks in their clients' portfolios, each of them purchased as a long-term investment, the partners of Chieftain do not need to find many new companies to add to their list. In some years, they buy no additional names, in other years three or four. This slow turnover leaves them time to keep thoroughly informed about the firms they do own, a necessity given the large stakes they maintain in each of their companies. All the partners go to the companies' meetings; all of them scrutinize the quarterly filings; and all of them keep current about the industry. They talk with management regularly, and they read the trade journals and other relevant material. In addition to the superior returns we described, their work has earned them the respect of the executives with whom they speak. They have been told by management that they understand the company better than all sellside analysts covering it.
Greenberg readily acknowledges, they make plenty of mistakes and are often quite inexact in their estimates of a company's revenues and earnings. They tend to err on the high side, which puts them in the camp of most analysts. How then have they done so well? For one thing, as value investors, they have not based their investment decisions on expectations of perfection. They do not buy high multiple stocks for whom an earnings disappointment can mean a punishing drop
The companies in their portfolio are sound enough to recover from short-term problems. As a consequence, the mistakes they have made have not buried them. Their poor investments, Greenberg says, have resulted more in dead money than fatal declines.
12 Robert H. Heilbrunn: Investing in Investors
Heilbrunn’s investment strategy based on this information is to buy stocks when they sell within the lower portion of their historical P/E multiple range, within the higher portion of their dividend yield range, or both. By establishing the ranges with precision, this approach provides a check on the emotions that can distort investment judgment, both the exuberance engendered by a rising market and the despair occasioned by a falling one.
13 Seth Klarman: Distressed Sellers, Absent Buyers
14 Michael Price: Discipline, Patience, Focus, and Power
Michael Price certainly does not rely on sell-side research, but he is willing to use it for a convenient summary of a complicated firm's business segments and as a check on his own valuation approach.
To estimate the intrinsic value of a firm, Price asks one question: How much is a knowledgeable buyer willing to pay for the whole company? He finds his answer by studying the mergers and acquisitions transactions in which companies are bought and sold.
how much they are insured for,
Don't deviate from the valuation standards, especially as the sirens of momentum are enticing the unwary.
second quality is patience: After the analysis has been completed and the intrinsic value is determined, don't chase the stock. It is important to wait for the market to offer a price with a discount large enough to allow for a margin of safety.
third virtue is focus: Don't be distracted by global predictions or macro forecasts, either by listening to them or making them yourself. It is much easier to understand a security than an economy, and the way to profit is by using that understanding.
15 Walter and Edwin Schloss:
Keep It Simple, and Cheap
Schloss are minimalists. Their office-Castle Schloss has one room-is spare; they don't visit companies; they rarely speak to management; they don't speak to analysts; and they don't use the Internet. they limit their conversations.
The Schlosses would rather trust their own analysis and their long-standing commitment to buying cheap stocks.
This approach leads them to focus almost exclusively on the published financial statements that public firms must produce each quarter. They start by looking at the balance sheet.
succinct response: We buy cheap stocks. Identifying "cheap" means comparing price with value. What generally brings a stock to the Schlosses' attention is that the price has fallen.
They scrutinize the new lows list to find stocks that have come down in price.
When they find a cheap stock, they may start to buy even before they have completed their research.
Schlosses believe that the only way really to know a security is to own it, so they sometimes stake out their initial position and then send for the financial statements. The market today moves so fast that they are almost forced to act quickly.
company's whose shares can be bought for less than the value of the assets will, more often than
