Value investing is, fundamentally, buying securities for less than they are worth and selling them when the market properly values them. This leaves the problem of valuation. Graham used asset value, that is, the liquidation value of the assets, which discounts values of inventories, technical equipment (which may be near obsolescence), etc. Although certain emperical discount values are given for the various assets, one can find a separate valuation by looking at what similar assets have sold for in recent transactions. Graham would buy securities whose market valuation was significantly less than this adjusted asset value such that it provided a good return and a margin of safety in case the market did not approach a proper valuation within a few years.
After the Depression these companies became harder to find and nearly impossible in recent years. Furthermore, Warren Buffett’s experience with Graham’s method was that indiscriminantly buying cheap companies did not work as well as the theory predicted: if the underlying economics of the business were bad, they stocks generally did not recover. There is a second method of valuing companies, however: earnings power value. EPV = constant earnings / cost of capital, is a measure of the return that investing a certain amount of capital will produce. If EPV > book value, then the company has a franchise, that is a market protected by barriers to entry. If the company invests within this francise it will create value. (Investing outside it will generally not increase value)
Some unusual companies can sustain high rates of growth in their franchise market. Fin de ciècle excitement over such companies led to a premium paid for growth. The authors examine Intel in the 1980s and determine that if the growth is likely to continue for a relatively long time and that both the growth rate and return on capital are substantially higher than the cost of capital, then a premium for growth may be warranted. However, the further one strays from assets, the less certain the valuation becomes. Growth is the most uncertain, and since the mark of a value investor is the margin of safety, in such extraordinary cases as Intel, growth may be used as the margin of safety.
The fundamentals having been explained, the second half of the book is devoted to eight successful value investors. These range from the best known, Warren Buffett, to quiet investors such as the Schloss’s. They have a significant range in ideology: Buffet buys entire companies with a strong franchise (Buffett), Klarman buys companies that have a non-economic factor depressing their price (such as being dropped from the S&P 500), Paul Sonkin invests in small companies, and the Schloss’ adhere much more closely to a Grahamian approach. Each of the eight investors’ principles are summarized and a historical example is provided, which illustrates the principles in valuation and the large variations within value investing.
Value Investing is an unassuming book that on first glance may fail to live up to its subtitle, especially if one is expecting an intellectual treatment of the material. Instead, it more closely resembles an instruction manual or a handbook. In fact, the copious examples and the well-explained concepts are reminiscent of Graham’s own handbook, The Intelligent Investor, although it is not as clear, as comprehensive, or as tempered with personal experience. Although the writing may not win any awards, the ideas are well summarized with valuable tidbits hidden in the biographical section and understanding and remembering these concepts with be a great aid to value investors in their endeavors.
Quality content, but lacks the spark of great content. Likewise, quality writing but not outstanding from a literary standpoint. The book aims to teach, and does so, but without the finesse necessary for the highest rankings. That notwithstanding, I would recommend this book to all beginning and moderately experienced value investors. Given that recommendation, I would rank this book as just under the 9.0 value that outstanding writing would achieve.
- Chapter 1: Introduction
- Value investing is buying securities when the price drops below their intrinsic value.
- It is not trend-based or economically based (buy when the economic conditions are good, sell when they are not).
- Value investors outperform the market by a greater margin than other methods.
- Volatility does not equal risk. If a price drops by 50% in a day it is high volatility but if that price is below what the company could be sold for, it is actually less risk.
- Chapter 2: Searching for Value
- Selecting based on ROE, ROC, growth (earnings/sales/assets), margins have not produced better returns than less glamorous stocks.
- Momentum trading (buy if it has gone up) generally outperfoms the market by about 3.7 percent if done for one year, but worse if done for three years.
- P/E, price to book, dividend yield are a measure of corporate fundamentals.
- In general, smaller companies have outperformed larger ones.
- What creates value? (i.e. why is the market not efficient?)
- Insitutional investors: index funds must add/drop securities as the indices change, some must drop securities based on debt, some are too big for small companies to make much difference (because they are limited on the percentage they can own), etc.
- Professional managers: picking a loser has a greater downside than the upside of risking to pick a winner
- People remember the near term better than the long term.
- Emotions: we don’t like losing money and we love making it.
- Chapter 3: Valuation in Principle, Valuation in Practice
- Present value (the amount a future sum is worth now) is often used in determining the worth of a company in the future.
- The calculation varies drastically with small changes in the rate.
- Estimating the growth rate for a long period of time (say ten years) has a large error.
- Combining these two factors results in huge errors.
- Three approaches to valuation
- Assets (book value): how much is the company worth if it is liquidated?
- Earnings power: EPV = adjusted earnings / cost of capital. (Earnings adjusted for “one-time” charges, mistakes in depreciation, needed capital expenditures, etc.
- If EPV > book value, the company has a franchise
Growth in the franchise creates value.
- If EPV < book value, growth destroys value.
- Growth: this is worth the least, because it is the least certain and it is the least immediate. (Chapter 7 determines that growth has to be quite a bit before it is worth much extra)
- Chapter 4: Valuing the assets
- Example of assets. The most notable concept is of making sure to uncover hidden assets, like securities or ownership of another company.
- Chapter 5: Earnings Power Value
- EPV is the amount of money the company can earn given its cost of capital (EPV = earnings / cost of capital (i.e. interest rate paid to the source of capital)).
- If money invested in the company earns a greater return than
the going cost of capital, the difference is the franchise value.
- Without barriers to entry, the franchise value is 0 (i.e. the rate of return = cost of capital)
- Barriers to entry
- patents, low costs, technological skill and experience. (Generally temporary)
- Customer demand (i.e. Coca-Cola)
- Customers’ aversion to change (why risk a new product not working as well as the current one?)
- High switching costs (“money, time, effort”)
- Economies of scale (if there is a fixed cost of creating the initial product, being the market leader means that that cost is averaged over more units)
- Brands are worth less than you might think. Mercedes is a powerful brand, but there is nothing stopping everyone else from duplicating the luxury experience, so it cannot charge much more than its competition.
- Chapter 5: WD-40
- The product is easily duplicated, but has lots of barriers to entry:
- Customers don’t want to experiment with a new product when WD-40 works.
- Competitors cannot underprice because saving 10% on $2 or $3 a can (which lasts most people forever) is not significant.
- Chapter 6: Intel
- Part of Intel’s assets are its knowledge: ability to
create the chips and iron out wrinkles in manufacturing.
- From 1980 - 1990 there were three times that market value were approximately equal to Intel’s (adjusted) asset value, either a little above or a little below.
- The EPV calculation is difficult for Intel because it is growing and therefore some expenses are due to growth and not the steady-state condition.
- Cash on hand needs to be added to EPV to reach a value for the company (buying the company would be buying the cash as well as the EPV).
- Intel’s barriers to entry are 1) consumer preferences (after being chosen by IBM it defined what x86 meant) and 2) economies of scale (more units sold than AMD)
- The franchise value is sanity-checked by finding a “franchise margin”, that is, the franchise value divided by (1 - tax rate).
- Present Value of growth = capital * (return on capital -
growth) / (cost of capital - growth)
ROC/R = 1.0
ROC/R = 1.5 ROC/R = 2.0 ROC/R = 2.5 ROC/R = 3.0 G/R = 25%
G/R = 50%
G/R = 75%
- In the 1987 - 1990 period, growth was worth at least 200% (i.e. 2.00 on the table). However, the value investor uses it as a margin of safety.
- Chapter 8: Constructing the Portfolio
- Value investors do not place too much stock in diversity.
- Why average great companies with mediocre ones?
- Cheap, good companies are less risk, so no need to diversify.
- Value investors do control risk:
- Corroborate conclusions by watching insider activity and respected investors.
- Ask why no one else has seen this golden opportunity
- Position limits: a stock cannot make up more than a certain percentage of the portfolio by value; as the stock price rises to its proper value, this will tend to cause the value investor to sell.
- Chapters 9 - 16: Eight Value Investors
- Warren Buffet: (chapter is quotes from his letters)
- Investment is allocation of capital.
- Buy great franchises in their entirety (presumably at a discount).
- Grahamian buy anything if it is for less than it is worth
empirically did not produce good results.
- “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
- “Time is the friend of the wonderful business, the enemy of the medicore.”
- Quality of management is paramount
- Mario Gabelli: Private Market Value
- “PMV equals intrinsic value plus a premium for
control”. The premium is useful when the buyer believes that they
can fix the business (replace management, etc.)
- “It takes something—an event, person, a change in perception—to narrow the spread between the market price and PMV”.
- Glenn Greenberg
- Small, concentrated portfolio (8 - 10 on average, no more than 20) of good companies bought cheaply.
- Robert H. Heilbrunn
- Knew more about people than stocks, so picked good people to manage his portfolio.
- “Several years ago, when Wells Fargo Bank looked like a promising investment to the value firm Tweedy, Browne, ... [they] reassigned the analyst [assigned to Wells Fargo] and simply bought the stock. They felt that their own research was unlikely to be superior to Buffett’s. Over the years, Heilbrunn has exercised a similar degree of judgement...” (p. 230)
- Seth Klarman
- In a bull market (e.g. 1982 - 2001) it is harder to find value.
- Motivated sellers: people who must sell (generally
institutional funds with some sort of constraints) cause an
artificially low price
- Index funds, when a stock is dropped from the index.
- Spin-offs (too small, or not worth the time to figure out if the spin-off is worth the price)
- Company files for bankruptcy
- Real-estate owned by people not in real-estate (ex: banks when a loan defaults): they are more interested in recovering some money than the right amount of money
- Finds investments that have a catalyst other than the market valuation to extract the value.
- Ex: bought senior Texaco bonds when it filed for bankruptcy. Texaco had plenty of assets to pay for it, but since Texaco had missed a payment, the bonds became defaulted and the price dropped by 10%. Yet the risk was not of losing money, but of how long it would take to get the money (which was $100 plus $12 interest plus $6 accrued interest). Turned out it was nine months.
- Michael Price
- Values assets by what values they have sold for in other situations (requires current knowledge of sales and bankruptcy liquidations)
- Often buys enough to be a substantial shareholder (> 5%), might make a move for a seat on the board, in order to get management to adopt actions beneficial to shareholder value.
- Only buys something with a 30 - 40% discount. Requires doing homework early and waiting for an opportunity.
- Walter and Edwin Schloss
- More traditional value investors: buy cheap stocks, preferably under asset value, although sometimes will factor in EPV.
- Generally does not pay more than three times book value for a company based on EPV.
- They try to determine what condition the assets are in—do they provide the ability for the company to turn around? If they once did but no longer, they sell the company, even if for a loss.
- Generally they buy too early and average down. Likewise they generally sell to soon.
- They own their stocks for four years on average.
- Paul D. Sonkin
- Microcap stocks offer the best opportunity for finding net-net stocks.
- Scans the new low list and asks himself what the prospects
for the company are.