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| ISBN-13: | 9780071733663 |
|---|---|
| Publisher: | McGraw-Hill Companies, The |
| Publication date: | 07/24/2009 |
| Series: | Chapters from Applied Value Investing |
| Sold by: | Barnes & Noble |
| Format: | eBook |
| Sales rank: | 1,056,835 |
| File size: | 2 MB |
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Applied Value Investing
By Joseph Calandro, Jr.
The McGraw-Hill Companies, Inc.
Copyright © 2009 Joseph Calandro, Jr.All right reserved.
ISBN: 978-0-07-173366-3
Chapter One
CONCLUSION
A general definition of intrinsic value would be "that value which is justified by the facts—e.g., assets, earnings, dividends, definite prospects."
—Benjamin Graham and David Dodd
Value investing, the strategy of buying stocks at an appreciable discount from the value of the underlying businesses, is one strategy that provides a road map to successfully navigate not only through good times but also through turmoil. Buying at a discount creates a margin of safety for the investor—room for imprecision, error, bad luck or the vicissitudes of volatile markets and economies.
—Seth A. Klarman
INTRODUCTION
Every now and then, when I pick up a popular business magazine, I come across an article that reports on some new quantitatively oriented trader who has come up with a system that processes fundamental information "in a manner similar to Graham and Dodd, except much more rigorously." In this context, rigorous usually means heavily mathematical. When I read things like this, I simply shake my head and put the magazine down. As I have demonstrated in this book, applied value investing is about identifying what you know and what you do not know, and then taking steps to quantify what you do know in a conservative yet rigorous manner so that a disciplined valuation can be formulated. This type of approach tends to optimally leverage business judgment—which usually is very costly to obtain—over time, and can be practically applied within the confines of a few broad rules:
• Do not invest outside of a well-defined circle of competence.
• Identify your own investment opportunities and value them conservatively within a disciplined framework.
• Invest only with a reasonable margin of safety. Transactions without a margin of safety are speculations, as Benjamin Graham stressed in his writings and as the noted modern value investor Seth Klarman also stresses in his.
In short, applied value investing is a discipline, not a system, and therefore mathematics is a tool, not a solution. One way of illustrating this is by examining the analytical layers of the approach as illustrated in Figure C-1.
In the following sections of this Conclusion, I discuss some of the key aspects of each layer of analysis illustrated in the figure. I then close this book with commentary on additional information sources for those who are interested in exploring this subject further.
SCREENING
Several quantitative variables have become associated with applied value investing over the years, including assets selling at
• Low market-to-book ratios
• Low price-to-cash flow, price-to-earnings, or price-to-sales ratios
• High dividend yields
There are many other quantitative variables that can be developed mathematically, depending on the objectives of an investor, portfolio manager, or M&A specialist. However, it is important to remember that whatever form a quantitative analysis may take, in a Graham and Dodd context it is only a screen, or the first layer of the analytical process. Quantitative screens are not systems, no matter how mathematically "rigorous" they may be. Consider Benjamin Graham's thoughts on this topic:
In forty-four years of Wall Street experience and study I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.
This quotation is an excerpt from an address that Graham gave in the year 1958, and yet as I edit this Conclusion in 2008, I am amazed at how current Graham's insight is. For example, the role that the abuse of higher mathematics played in the credit crises of 2007–2008 vividly illustrates how little investors in general, and Wall Street in particular, seem to have learned in the last fifty years.
Screens can also be qualitative in nature. For example, a qualitative screen could be based on business cycle analysis, as shown in Chapter 5. Another qualitative screen could involve franchises, which admittedly can be difficult to identify, especially early on, meaning right after a franchise has been formed, when it is just starting to generate economic returns.
A friend of mine conducted an informal but interesting study on franchises. Essentially, he went back in history and discovered that a number of well-known franchises were profiled in popular magazines such as Time somewhat before their stocks were widely recognized on the market. The results of this study are private (meaning that they are not being published), but its example illustrates how qualitative and publicly available information could potentially be used to screen for franchise-based opportunities.
Qualitative sources could also be used to identify special situation–based value investment opportunities, such as bankruptcies, spin-offs, and restructurings, which are reported on in newspapers, on the Internet, and in specialty publications.
In practice, I generally recommend the use of both quantitative and qualitative screens. While this practice can generate a great deal of information, it has a natural filter in the circle of competence; in other words, one's circle of competence will determine how much information needs to be generated to efficiently identify possible investment opportunities for further consideration in an initial valuation.
INITIAL VALUATION
An initial valuation is a working hypothesis of value that is based on research and applied business insight. An initial valuation is used to assess whether a screened potential investment opportunity could contain a reasonable margin of safety, and thus qualifies as a candidate for more in-depth levels of analysis. In the following subsections, I highlight key initial valuation considerations by level of value along the modern Graham and Dodd continuum.
Net Asset Value
Valuation as described in this book begins with balance sheet analysis and net asset value (NAV). The discipline of reconstructing a balance sheet, line by line, on a reproduction basis helps to level-set assumptions, and by so doing helps to ground a valuation in the facts, as noted, for example, by Graham and Dodd in the quote that opens this Conclusion.
Most balance sheet adjustments are fairly straightforward; for example, the mechanics of adjusting receivables, inventory, land, and even reserves can be fairly obvious (this is not to say that deriving these adjustments is easy, only that the approaches to deriving them are fairly well known). The goodwill adjustment, however, can be somewhat complex because it is intangible.
In a modern Graham and Dodd context, goodwill frequently encompasses a blended adjustment of a wide range of intangible assets. Not only can the scope of this adjustment be incredibly wide, but the basis for it—a multiple of the selling, general, and administrative expense—is extremely subjective. Frankly, this adjustment is the only part of the modern Graham and Dodd approach that I feel needs to be further developed. One step in the development process could involve mapping the components of intangible assets that are included in the goodwill category. Consider the example presented in Figure C-2.
The figure presents a "strategy map," based on the seminal work of Robert Kaplan and David Norton, that illustrates the basic components of the goodwill category. I made several adaptations to the original diagram. First, I grayed out the "Revenue Growth Strategy" boxes because growth is assessed in the final level of value along the continuum, not at the NAV level. I also identified key intangible assets in bold capital letters. Working from the top of the diagram down:
• Cost is the first variable identified. Low-cost products can generate substantial goodwill over time, as we saw in Chapter 3 with GEICO. Other well- known examples include Progressive Insurance, Wal-Mart, and Target.
• Price is the second variable because increased customer value should equate to pricing power. Microsoft is a contemporary example of this, while Gen Re in the 1960s to early 1980s is a historical example (as noted in Chapter 4).
• Brand is the next, and arguably the most important, intangible asset. For example, bestselling author and former CEO David D'Alessandro stated, "'Will it help or hurt the brand?' is the most useful of all mantras in the marketplace. It is the prism through which every business decision, major or minor, can and should be made." Similarly, value investor Thomas Russo noted that an objective of modern Graham and Dodd–based practitioners is to "find businesses selling at reasonable prices with superior brands that possess genuine competitive advantage." For example, powerful brands were identified in Chapter 2 as a substantial part of my Sears valuation. As another example, substantial brand value would also likely be reflected in virtually any valuation of Johnson & Johnson.
• Every firm strives to be innovative, but very few firms are able to be consistently innovative over time. Apple is an example of a successful innovation-based firm, as are Microsoft and IBM. GEICO has also been incredibly innovative with respect to its highly entertaining marketing campaign, as noted in Chapter 3.
• Next to brand, organizational capital may be the most important intangible asset. An example of this is Goldman Sachs's and JPMorgan Chase's performances in 2007 following the subprime contagion compared to that of many other financial institutions. Obviously, there can be numerous factors behind these firms' relative success, but I would argue that most of those factors probably emanate from their organizational capital base, which is what seems to have inspired Warren Buffett to invest in Goldman Sachs (on a distressed basis) in 2008.
Decomposing goodwill into discrete categories like this facilitates more focused levels of analysis, which can range from simple ratio-based analysis to more intensive forms of statistical and private market value–based analyses, depending on the complexity of the valuation at hand. This type of approach seems more consistent with the underlying philosophy of Graham and Dodd–based valuation than simply aggregating all of a firm's intangible assets into one subjective, multiple-based adjustment.
Earnings Power Value
Estimating sustainable operating earnings or earnings before interest and taxes (EBIT) is fundamental to earnings power valuation and can be somewhat complex. There are a variety of ways to approach this estimation, samples of which were provided in Chapters 1 through 4 of this book. There is no one way to make this estimate, which is one of the reasons why the circle of competence is so important: investors or analysts must know which approach is right for the particular firm they are valuing at the particular time they are valuing it.
As noted in prior chapters, most valuations end after EPV because most firms are not franchises. However, when EPV is substantially greater than NAV, the firm being valued may be a franchise, and therefore requires further analysis.
Franchise Value
Franchise valuation can present a variety of significant challenges. First, franchises are inherently intangible and thus inherently difficult to value. Furthermore, many franchises have finite life spans; for example, academic studies suggest that there is a general franchise life span, or competitive advantage horizon, of approximately five to ten years. A dramatic example of a finite franchise life span, and the risks it can generate, was presented in the Chapter 4 valuation of Gen Re.
Franchise analysis is rooted in strategy, which can seem simple— especially with the benefit of hindsight—but in practice can be inordinately confusing and complex. Fortunately, base-level franchise considerations seem to be relatively clear:
• A track record of economic returns, which can be defined as a return on capital (ROC) greater than the weighted-average cost of capital (WACC) or a return on equity (ROE) greater than the cost of equity, over time.
• A very clear strategy, or some unique way in which a firm creates value for its customers. Uniqueness is very important in franchise valuation because without it there is no franchise; in other words, if the firm you are valuing is similar to other firms in its industry, it is not a franchise. Needless to say, not many valuations will pass this litmus test.
• An executive team that is focused on both implementing the strategy and perpetuating it over time.
Evaluation of the second and third of these items is likely to require substantial strategic-based research and analysis, which can be highly specialized and somewhat involved. As this is not a strategy book, I will identify strategic references that could be consulted for further information in the Resources section.
Growth Value
Growth is the final level of value along the modern Graham and Dodd value continuum, and it is the most intangible level of value. Growth is also one of the most difficult ways to earn a superior return over time. The reasons why involve macro-based, market, and micro-based considerations.
Macro-based considerations are the easiest to explain: when markets are booming, growth-based strategies tend to do spectacularly well, and they can be fairly easy to implement. An obvious recent example is the Nasdaq index during the "new economy" boom of the late 1990s, as profiled in Chapter 5. The "buy on dips and then hold on" and "buy the latest technology IPO" approaches did very well while the Nasdaq was booming. An incident that I witnessed one day provides a dramatic example of this.
On the train to work one morning, I sat directly across from two very nice ladies who appeared to be average, middle-class workers in their late fifties to early sixties. Part of their discussion that morning went something like this:
"Did you read that Warren Buffett is not investing in technology stocks because he doesn't understand them?"
"Oh, my."
"Yes, I know. He's really missing out. What a shame. He was once so successful. Too bad he hasn't kept up with the times. My technology stocks are up over 100% already this year, and I see a lot of upside—so much so that I plan to retire soon."
The poignancy of this moment—which occurred as the Nasdaq was nearing its top in early 2000 (and therefore, as of 2008, the person who made the comment about retiring soon is probably still hard at work)—is impossible to capture in writing, but it illustrates my point: when markets are booming, even the most basic growth strategies can generate exceptional returns for practically anyone who employs them. Of course, those returns will end when a bust ensues, as it invariably will, but it could take years for that to occur.
Market dynamics also tend to limit growth opportunities. Growth inherently reflects increasing levels of demand, but the economic profit generated from that demand is a signal that will attract the attention of competing firms, which will try to capture some of that profit through innovative products, services, or cost offerings of their own. Still other competitors will try to anticipate shifting demand and therefore concentrate on emerging opportunities that can erode or eliminate base demand. Such disruptive change-oriented strategies have been written about extensively and can destroy established growth initiatives.
From a micro-based level, growth creates value only if it occurs within a franchise. Managing a franchise requires focused discipline on delivering a unique value proposition; however, growth often requires substantial innovation. Balancing these two aspects—namely, focused management on the one hand and innovative strategy formulation and execution on the other—can be extremely difficult over time. Firms that are able to balance the two, though, can create substantial value over time.
Margin of Safety
To sum up, once an initial valuation has been prepared, a preliminary determination can be made as to whether an investment seems to contain a reasonable margin of safety. A rule of thumb is that the margin of safety should be at least 30 to 33%, and preferably much larger. If a valuation meets this rule, the next step is to validate the initial adjustment and calculation assumptions.
NAV ADJUSTMENTS
The extent to which independent appraisers, experts, auditors, and other such professionals are retained to validate an initial NAV adjustment is contingent upon the scope and scale of a particular valuation and the way individual value investors practice their craft. For example, as Roger Lowenstein observed in his introduction to the sixth edition of Graham and Dodd's Security Analysis, "while some investors rely strictly on the published financials, others do substantial legwork. Eddie Lampert, the hedge fund manager, visited dozens of outlets of auto-parts retailer AutoZone before he bought a controlling stake in it."
(Continues...)
Excerpted from Applied Value Investing by Joseph Calandro, Jr. Copyright © 2009 by Joseph Calandro, Jr.. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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