Value Investing Principles
Identify enterprises whose value as a business is reliably calculable by you (circle of competence) Among those enterprises, invest in those whose market price (equity plus debt) is below your calculated value by an appropriate margin of safety (1/3 to 1/2)
Earning Power and Entry - Exit
Case A:
Value Lost to Poor Management and/or Industry Decline
Asset Value EP Value
Case B:
Free Entry Industry Balance
Asset Value EP Value
Case C:
Consequence of Comp. Advantage and/or Superior Management
Asset Value EP Value
Sustainability depends on Continuing Barriersto-Entry
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Varieties of Competitive Advantage
Producer (Cost) Supply Proprietary Technology or Resources Consumer (Revenue) Demand Customer Captivity Economies-of-Scale (plus Customer Captivity)
Key to Sustainability
Sustainable Competitive Advantage implies market dominance.
Varieties of Competitive Advantage
Proprietary Technology Proprietary Resources
Not smarter; or deep pockets involved
Captive Customers Not Brands Habit Search Costs Switching Costs Problem is that these advantages die with technology and consumers.
Economies of Scale, however, apply in market for new technology (Intel) and new customers.
Competitive Advantage Strategy Implications
Analysis on a market-by-market basis Large global markets are difficult to dominate Local markets (Physical, product geography) are ones susceptible to domination Microsoft (Apple, IBM) Wal-Mart (K-Mart, Circuit City) Intel (Texas Instruments, et al) Verizon (ATT, Sprint) Pharmaceuticals
Value Investing Process
SEARCH
Cheap Ugly Obscure Otherwise Ignored
VALUATION
Assets Earnings Power Franchise
REVIEW Key Issues
Collateral Evidence Personal Biases
RISK MANAGEMENT
Margin of Safety Some Diversification Patience Default Strategy
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Basic Elements of Value
Strategic Dimension
Growth in Franchise Only Franchise Value Current Competitive Advantage
Free Entry No Competitive Advantage
Asset Value Earnings Power Value Total Value
Reliability Dimension
Tangible Balance Sheet Based No Extrapolation
Current Earnings Extrapolation No Forecast
Includes Growth Extrapolation Forecast
Total Value Including Growth
Least reliable - Forecast change not just stability (Earnings Power) Highly sensitive to assumptions Data indicates that investors systematically overpay for growth Strict value investors want growth for Free (Market Value < Earnings Power Value)
Value of Growth - Basic Forces At Work
Growing Stream of Cash Flows is more Valuable than a Constant Stream (relative to current Cash Flow)
Growth Requires Investment which reduces current (distributable) Cash Flow
Value of Growth - Basic Algebra
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Valuing Growth
Case 1: ROC Return on Capital Cost of Capital R Then ROC G R G = = 1 (for all growth rates) RG RG
e.g. (ROC = R = 10%)
ROC = R when there are no Barriers-toEntry (i.e. no competitive advantages level playing field) then Growth has no Value.
G = 0%
ROC G R-G
10 - 0 =1 10 - 0 10 - 2 = 1 10 - 2 10 - 8 =1 10 - 8
G = 2% ROC G = R-G G = 8% ROC G = R-G
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Valuing Growth
Case 2: Competitive disadvantage with growth ROC less than cost of capital then ROC G < R - GROC G < 1 RG and ROC G gets smaller with higher growth rates. RG
e.g. (ROC = 8%, R=10%) G = 0% ROC G= 8 - 0 = .8 R-G 10 - 0 G = 2% ROC G = 8 - 2 = .75 R-G 10 - 2 G = 8% ROC G = 8 - 8 = 0 R-G 10 - 8
Higher Growth at a Competitive Disadvantage Destroys Value
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Valuing Growth
Case 3: ROC is greater than R Firm enjoys a competitive advantage (franchise) Shares are stable G = Industry Growth Rate then ROC G is greater than R G and ROC G is greater than 1 and increasing in G. RG
e.g. (ROC = 15%, R = 10%)
G = 0% ROC G = 15 - 0 = 1.5 R-G 10 - 0 G = 2% ROC G =15 - 2 = 1.625 R-G 10 - 2
Only within Franchise Growth creates Value
G = 8% ROC G = 15 - 8 = 3.5 R-G 10 - 8
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Value of Growth Quantitative Effects
Investment: Cost of Funds:
$100 million 10% (R) = $10M
Return on Investment (%) Return on Investment ($) Cost of Investment Net Income Created Net Value Created
5% $5M $10M ($5M) ($50M)
10% $10M $10M 0 0
20% $20M $10M $10M $100M
Qualitative Impact:
Value Destroyed Competitive Disadvantage
No Value
Value Created Competitive Advantage
Situation:
Level Playing Field
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Valuing Growth Basics
Growth at a competitive disadvantage destroys value (AT&T in info processing) Growth on a level playing field neither creates nor destroys value (Wal-Mart in NE) Only franchise growth (at industry rate) creates value
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Valuing Growth - How much Does it Add?
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Procedure in Practice
(1) Verify existence of franchise
i. ii. History Returns Share Stability Sustainable competitive advantages
(2) Calculate earnings return i.e. 1/PE (3) Identify cash distribution portion of earnings return
(Dividend + Repurchase)
(4) Identify organic (low investment) growth
(GDP)
(5) Identify reinvestment return
(Multiple of Pct retained Earnings )
(6) Compare to market return (D/P & growth) (7) Identify options positive/negative
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Simple Examples Franchise Verification
Company
Wal-Mart
Business
Discount Retail
Adjusted ROE
22.5%
American Express Gannett
High-end Credit Cards & Services Local Newspapers & Broadcasting
45.50%
15.6%
Dell
Direct PC Supply to Large organizations
100.0% +
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Simple Examples Franchise Verification Sources of Competitive Advantage
Sources of Competitive Advantage Company Wal-Mart Customer Captivity? Slight Customer Captivity Economies-of-Scale? Local Economies-ofScale Some Economies-ofScale Local Economies-ofScale Economies-of-Scale
American Express Gannett
Customer Captivity
Customer Captivity
Dell
Slight Customer Captivity
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Calculated Growth Stock Returns
CASH RE GROWTH TOTAL
Wal-Mart
= 1.5%
+ 4.5% +
(x1 Capital Allocation)
3.5%
9.5% + Option
(P/E 17, Growth 11 %)
American Express
4%
+ 4%
7.5%
= 15.5% + Option
(P/E 17 , Growth 13%)
(2% x 2)
Gannett
(P/E 11, Growth 3%)
= 10%
1%
2.0%
7.0% + Option
Dell
0%
+ 5%
(?)
5.0% + Growth
+Option
(P/E 20, Growth 15%)
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Growth Stock Evaluation Adidas
Does the Franchise Exist?
Sources of Competitive Advantage Proprietary Technology No Customer Captivity Some Economies-of-Scale Yes (Advertising, Distribution Regional)
Key Question What will Nike Do?
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Growth Stock Evaluation Adidas
Does the Franchise Exist?
Industry Returns (2003-5)
Company Size ($B) Sales ROE ROIC ROS (OI) ROS (NI) Adidas 8.3 18.3 33.0 9.5 4.7 Nike 13.7 21.2 37.3 12.6 7.8 Puma 2.2 40.0 137.6* 23.0* 16.6
* Negative Trend
Reebok -- Acquired by Adidas ($40B) Converse Acquired by Nike New Balance Private (WW Sales - $1.6B)
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Growth Stock Evaluation Adidas
Does the Franchise Exist?
Share Stability Recent History Older History No Entry, Consolidation 1989-92 Adidas wiped out by Nike 1992-98 Recovery 1998-2000 Stagnation
Share Stability Europe 2003 Adidas Nike Share Chg 45 55 2 2005 43 57 North America 2003 25 75 2 2005 23 77 Asia 2003 45 55 1 2005 44 56
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Growth Stock Evaluation Adidas
Relative Returns
CASH RE GROWTH* TOTAL
Adidas
1.0
4.0
(5.0%)
4.0
(9.5)
= 10.0 + Option
(PE 16 2/3 x)
Nike
1.5
(PE 14 )
5.5
(5.5%)
5.0
(13.0)
= 11.5 + Option
Puma
1.0
(PE 16 x)
5.0
(5%)
5.0
(13.0)
= 11.0 + Option
* World GDP plus minimal margin improvement (currently 12-15% plus margin improvement)
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Evaluating Growth Stocks
Results
Stock Return
Wal-Mart Gannett American Express Dell Dow-Jones Index Nike Adidas
10.1 1.0 11.6 -20.0 19.7 24.5* 2.7*
* Price change since July 2006
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Value Investing Process
SEARCH
Cheap Ugly Obscure Otherwise Ignored
VALUATION
Assets Earnings Power Franchise
REVIEW Key Issues
Collateral Evidence Personal Biases
RISK MANAGEMENT
Margin of Safety Some Diversification Patience Default Strategy
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Elements of Risk
Building
Rental Stream changes (Mgt competition industry shift)
Intrinsic Value
Building Price Fluctuations (Less important unless need to sell) Wrap in Reit Reit Price Fluctuation
Pvt Market Value
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Risk Management in the Value Process
Risk is not the same thing as Uncertainty Highly certain losses are surely an element of Risk Upside possibilities that are highly Uncertain do not necessarily constitute Risk.
Sources of Risk are as Important as Risks themselves Unanticipated Negative development Miscalculations of Positive values. (Underestimation of negative values)
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Value Investing Risk Miscalculation
Diversification may be Underestimated Margin of Safety will be Miscalculated Protection Against Miscalculation External references Insiders Search strategy Other value Investors Internal References Careful tracking Success/Failure Pre Consideration of Default Strategy
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Relative VS. Absolute Risk The Default Strategy
Absolute Risk Capital Preservation
Minimize Deviation (Return Return on PNVO) PNVO is the Portfolio with Best Return with No Value Opportunities Available = CASH?
Relative Risk Index Performance
Minimize Deviation (Return Return on PIndex)
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Risk Management in the Value Process
Risks are Situational In some cases Asset Value Miscalculations Dont matter In other cases, Earnings Power miscalculations dont matter Negative surprises can be Minimized Situations: Asset-Based Purchase Franchise-Based Purchase Joint-Based purchase
AV > < = EPV =P =P >P
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Asset Based Purchases Unanticipated Negative Development Asset Impairments Management Depredations (A) Industry Deterioration Accounting Irregularity
Check Situation Specific
(B) (C)
Non-Performing Catalyst Economic Deterioration (Depression, Nuclear War)
Situation Specific
(A) & (B) Diversification and Margin of Safety (C) Margin of Safety
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Franchise Purchases
Negative Developments
Management Impairments - SMALL Asset Impairment - NONE Accounting Irregularity RARE Non-Catalyst UNNECESSARY Industry/Economic Impairment LIMITED Franchise Impairment - CRITICAL
Sector Specific Event
Diversification Growth as a Margin of Safety VS. Industry/Economy Impairment
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Joint Purchase Based
Company Impairments Industry Impairment
- DIVERSIFICATION
Economy Impairment MARGIN OF SAFETY
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Security Analysis
What Do you Do When There are No Good Ideas? How Much Do you Buy?
Know Nothing Modern Portfolio Theory World Define DEFAULT Risk Minimizing Portfolio
Determining
(1) Equity Manager Index Fund (2) Individual Optimal Index + St. Portfolio (3) Value Manager Statistical Value Index Fund
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