Monday, April 7, 2014

What is Value?

When the Globe & Mail inquired about my investing style, I had to choose the word "Value".  I believe a value based approach is the only sound investment approach that can achieve sound results. Although not everyone wants to be value investors, I believe every investors can benefit by learning value based investment principles. 

Value Is All About Pricing and Not Timing 
In Security Analysis, Ben Graham described two different methods for predicting future security values. One is timing and the other is pricing. In essence, timing  involves predicting future stock prices based on past information. Timing is dangerous because investors often extrapolate past trends into the future without ever questioning if the past trend can continue. The better approach is pricing, which involves the estimation of intrinsic value. The pricing approach is more dynamic and it captures the value of the underlying business through the estimation of future earnings power and cash flow

One example of timing is using past returns to predict future returns. Momentum investing, the act of buying past winners, has become very popular lately but there are numerous dangers with this approach. Investors often see the following warning on fund prospectuses: "past returns or performance is not an indication of future returns". Yet even with this warning, many investors still rush to buy momentum stocks because they believe past performance will continue. However, as Herb Stein famously observed, "if something cannot go on forever. It will stop". A $1 billion company can grow into a $10 billion company, but it may be extremely difficult to grow the same $10 billion company into a $100 billion company. Mathematically, it becomes harder and harder to grow a company at the same percentage rate because the base (in dollars) becomes larger.

The timing approach also includes market timing, the act of trying to guess future prices based on past price patterns or intuition. Again, past price patterns are not reliable indicators of the future and guessing prices based on intuition is really unintelligent speculation. There is no guarantee that prices will move in the direction predicted and those who practice this approach will often lose money on average. Market timers may have great gains once in a while but they will also have great losses. The act of making continuous "bets" on the stock market is not a sound approach of building long term wealth. 

The pricing approach is attractive because it analyzes the underlying value of the company and avoids unnecessary speculation on the future price by ignoring the stock price. Instead, investors who practice pricing are more interested in the performance of the business rather than the performance of the stock price. Unlike the timing approach, the pricing approach is sound. Practitioners under the pricing approach avoid the extreme emotions of the stock market and can be confident that value can converge near their intrinsic value estimate if they have conducted a thorough analysis.

To answer the question in the title, value is all about buying dollars for fifty cents. I will provide three sources of value in the sections below which will help readers find dollars that are selling for fifty cents because the crowd neglected to analyze the sources of value. 

Value in a Cigar-butt (Method 1): 
This was the main approach advocated in Graham's Security Analysis and The Intelligent Investor, which was referred to as the purchase of bargain issues. Buffett later named this method as the cigar-butt approach.

Under Graham's original approach, a bargain issue was a company selling below 2/3 of net-net value where net-net value is defined as working capital minus outstanding debt. Readers should note that by buying companies at 2/3 net-net value, the investor has at least a 50% margin of safety if the stock returns back to net-net value. Net-net value is extremely conservative because it only considers the liquid assets of the company while ignoring the value of all fixed assets.

Not many companies sell below net-net value presently but many obscured small-cap may fall below net-net value from time to time. These net-net stocks were very profitable because the valuations were so cheap that a small positive development can push the stock up 50% or even 100%. A diversification policy should be followed if readers want to practice buying cigar-butt companies. Many of these companies are often cheap for a reason but a broad basket of these net-net stocks yields sound results over time. Walter Schloss, who worked at Graham's firm in the 1950s, practiced cigar-butt investing for nearly five decades. He managed to earn a 15.7% compounded return (after-fees) vs. S&P500's 11.2% over 45 years. He holds about 100 stocks but they were all cheap cigar-butt stocks.

Although not many companies sell below net-net value, investors can consider buying companies selling significantly below the reproduction cost of the net assets on the balance sheet. That value can be calculated by adjusting the book value to reflect the actual cost of reproducing the various assets or liabilities. If investors can buy at 2/3 of the reproduction costs, it can be considered as a modern day cigar-butt but the classic definition offers a better margin of safety.

Value from this method is derived mainly from the assets owned by the company and the focus is solely on the balance sheet. If investors acquire cigar-butt stocks at low prices, the reversion to the correct asset value can yield handsome rewards for investors. Even though asset values can deteriorate, a low price paid and adequate diversification can often compensate for that risk. 

Value in Economic Moat and Talented Management (Method 2): 
This approach is practiced by Buffett. After Buffett met his business partner Charlie Munger in the early 1960s, he realized that there are value in intangibles like competitive advantages and talented management. Before meeting Munger, Buffett was only buying cigar-butt stocks as described in the prior section. 

Buffett's classic example of using this approach was the purchase of See's Candies in the 1970s. Berkshire bought See's at 5 times tangible book value, which would have been crazy under classic Graham rules. However, Graham's rules ignored intangibles such as the large economic moat enjoyed by See's. Economic moat was the term Buffett created to describe the competitive advantages possessed by the underlying business. 

The company was well known in California and has a well established customer base. Another feature that Buffett noticed was that See's had the ability to raise prices to combat inflation without losing customers. With a high return on capital and low sustaining capital required to run the business, See's can generate a valuable and growing cash flow stream for Buffett, which he can reinvest in other businesses or stocks for Berkshire Hathaway. 

Management was also quite talented at See's. They ran the operations extremely well and had good capital allocation skills, a trait highly valued by Buffett.  Most corporate CEOs often have poor capital allocation skills, which can destroy shareholder value because they squander a large amount of capital on exorbitant acquisitions or low return projects. Both initiatives can increase reported earnings but not underlying value. See's management ran the operations with minimum reinvestment and were modest in their spending plans. 

Although See's was a private transaction, investors can apply the same principles in stock market investing because stocks are businesses. In fact, investors can buy a company similar to See's at a much lower price since, in theory, Buffett's price included a sizable control premium. Therefore, look for companies with strong competitive advantages such as the ability to raise prices. High return on capital and low capital reinvestment are two key characteristics of these attractive businesses. Furthermore, a strong management with good capital allocation skills can add considerable value.

Value from this method is derived mainly from the company's ability to generate consistent incremental earnings (high earnings power) and cash flow because of its competitive advantage and talented management team.

Value in Profitable Growth (Method 3): 
The right approach to growth investing is profitable growth. Under this approach, investors should purchase, at a reasonable price, firms that are expected to grow earnings faster than average and are expected to maintain or grow its return on capital. 

Profitable growth is not the same as absolute growth. Absolute growth may refer to large percentage increase in revenues or earnings over a short period of time. As a result, investors often assign generous earnings multiples on these absolute growth firms with P/E ratios north of 25. The high multiples assigned to many growth stocks are not justified because the high valuations already reflect their high growth potential. Furthermore, absolute growth can be an illusion if growth is not accompanied by increased profitability. Many investors measure profitability by earnings growth rates but ratios such as return on capital (EBIT/Total Capital) are better at assessing profitability. Earnings can grow but return on capital will decrease if management decides to conduct lower return projects in order to meet absolute earnings targets. Although earnings can grow in this manner, the incremental earnings are value destructive if return on capital drops, especially if return on capital drops below the cost of capital. Therefore, profitable growth companies increase earnings and return on capital at the same time, which result in efficient capital allocation and higher value.  

In order to assess the attractiveness of the current valuation vs. future growth potential, investors need to spend time analyzing the business and project future earnings streams under conservative assumptions. For example, growth rates should gradually diminish as the size of the firm becomes larger. Graham suggested projecting earnings 5-7 years out and apply a conservative earnings multiple less than 20 times the average projected earnings. Investors should favour growth but be wary of the price paid for growth. 

If investors find an attractive growth opportunity, ask three simple questions: (1) Does the current price reflect the growth expectations already? (2) Is the company selling below 20 times the average projected earnings? (3) Can the company grow earnings while growing or at least maintaining its return on capital? Because high growth firms tend to sell above market multiples, investors often overpay for them. Nevertheless, these profitable growth firms can offer stellar returns if they are bought at rational prices. Ten baggers, firms that increase in value by 10 times, are often profitable growth firms. 

Value from this method is derived mainly from the company's ability to maintain profitable growth over a long time period. This value can be negative if investors pay a high price for profitable growth.

Growth vs. Value Investing?
Because I discussed growth investing in the prior section, I want to give my opinion on whether value is better than growth. In my mind, there is no distinction between value and growth. In fact, growth is a component of value. Ben Graham may be known as a value investor who loves to purchase net-net stocks (stocks that trade below tangible working capital), but he also championed a growth stock approach. For those who have read the original 1949 version of The Intelligent Investor, he stated that a growth stocks add value for an intelligent investor's portfolio only if bought after a thorough analysis of its prospects 

In my opinion, the definition of growth and value used by finance professionals is wrong and misleading. A low P/E ratio, low P/B ratio, and high dividend yield are not strict yardsticks for value as commonly defined in financial literature. A stock can be a value stock despite having a high P/E ratio, high P/B ratio and low dividend yield. When Buffett bought Coca-cola in 1988, the stock's P/E ratio was in the high teens and P/B ratio was well over 5. The stock was nonetheless a value stock in Buffett's view because its future earnings power justified a high intrinsic value. On the other hand, a stock with low P/E, low P/B and high dividend yield may not be a value stock because its future earnings power is in a structural decline. A low P/E ratio may be misleading because the "E" in that ratio can decline rapidly in the future. Similarly, a low P/B ratio may be misleading because the "B" in that ratio is too high. Future operating losses can lower the "B" and the low P/B ratio will vanish. 

By the same token, a growth stock is often defined as one that has increased earnings or sales at a high rate in the past few years. Investors often make the mistake that past growth is an indication of future growth.  Also, investors are misled by absolute growth numbers. Growth can be value destructive if the incremental earnings is created by reinvesting more capital at a lower rate of return.

In short, if I was asked whether I prefer value or growth, I would answer value. However, I don't think there is a difference between value and growth. Growth is a component of value and can be extremely valuable if investors can identify profitable growth at reasonable prices (as discussed in section above). Even though I detest the standard definition of value investing, investors who buy stocks with low P/E, low P/B and high dividend yields should experience better investment results than those who buy high P/E, high P/B and low dividend yield stocks. 

The Bottom Line: 
In the 1949 original edition of The Intelligent Investor, Graham famously stated that "it remains true that sound investing principles usually produce sound results." Investors should look for stocks that have the three sources of value as described in this article. Method 1 and 2 offer more safety than method 3 because method 3 requires the estimation of future earnings growth, which can be tricky for fast growing firms.

Intelligent investing is all about pricing and not about timing. Investors who want to practice timing should warned that they are speculating, which can be profitable but also risky at the same time. Intelligent investors who buy a portion of a business at a rational price should expect good results on average and minimal loss of capital. By investigating the underlying business through pricing, investors can unlock hidden values that are often overlooked by short term oriented investors.

By finding those sources of value, an investor can buy a dollar for fifty cents! 


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