Book: Value Investing – from Graham to Buffett and Beyond
Author(s): Bruce Greenwald, Judd Kahn, Paul Sonkin, Michael van Biema
This is a great book. It has three parts–first, where the author defines Value Investing, second where it talks about sources of value, and finally it talks about the practitioners who “do” value investing and how they do it. I found the first two parts most useful, mostly because I was familiar with writings/concepts that are broadly attributed to most of the practitioners that the book profiled–Buffett, Klarman, Schlosses and Greenberg. The book also talked about Mario Gabelli, Robert Heilbrunn, Michael Price and Paul Sonkin. The third part is also the hardest to go through because the text is often disjointed, as the book makes brief jumps from one practitioner to the other. You can almost see that the authors sunk 95% of the their work in the first two parts. But, the book is richer for it because you can learn the lessons from the third part with a little bit of your own work easily anyway.
Part I – What is Value Investing? And, where can one find value?
I think the book is worth its money just for this part, as it articulates very well what is often a slippery and coy characterization of ‘value investing’ whenever I have seen someone attempt it. Greenwald says that value investing is where (1) one is concerned with the level of prices relative to underlying value, as opposed to change in prices of the underlying, and (2) there is an identifiable margin of safety. The second part is more easily understood, but the first bit is more interesting. It says that fundamental investors (who’re not value investors) are concerned with identifying the factors that make prices go up or down and then attempt to trade on those fundamentals. Value investing, on the other hand, almost assumes that the secondary market doesn’t exist and then try to ascribe a value to the business and compare it to prices. For many fundamental investors, price is often the point of departure for their analysis.
As for where to find value, it lists the following, which isn’t very novel, but is a good compilation:
- spin-offs (Klarman mentioned this in his book Margin of Safety)
- smaller companies (usual reasons)
- institutional biases or legislative actions limiting all information from pricing
- behavioral biases (extrapolating, avoiding something obscure, and loss aversion) — well explained in Amos Tversky’s papers and Daniel Kahenmann’s book Thinking Fast and Slow
Part II – Three Sources of Value
Value = asset value + franchise valuation + optionality of growth
Value of the assets: If the cost of capital and the return on capital is the same, then value of the company is the same as the value of invested assets, which is one of the reasons why this methodology is valuable. Also, if the industry is sustainable, then this value is the most easily calculable, and are less subject to judgement when compared to the estimates of future distributable cash flows of the company. If the industry is sustainable, the assets are valued at “reproduction costs”, but if the industry is likely in a terminal decline, or there is no industrial buyer of the assets, then most of the assets are valued as scrap. Below, we go step by step for each of the major line-items –
- Cash and equivalents: unless the company has some really dodgy level-3 marketable securities in here, this is pretty straight-forward.
- Accounts Receivables: most of this is recoverable, but assumes that there is are specialists who can recover their value and the legal system allows for that, and that the customers are themselves not declaring bankruptcy in a country where trade debt is not honored in bankruptcies. One also needs to keep an eye on the estimate of the contra-asset ‘allowance for doubtful accounts’ which also may also need to be adjusted from the last estimate by the accountants.
- Inventories: one can estimate the normal amount of inventory (in $s / volume, if prices are fluctuating heavily / days of inventory), and then try to figure out the “piled up” inventory. Some other judgement may also be required, if the inventory is seasonal and/or made for specific use/customer. LIFO vs FIFO must also be explored.
- Plant: first thing we need to check how the plant has been depreciated in the past as does that correspond with the economics of the asset. Since plants often have a long usable life, inflation is also a concern, and we need to make sure that the accountant’s number (unadjusted for time value of money) is reflective of the economics.
- Property: this is essentially estimating land value, which is booked at cost under GAAP
- Equipment: best estimated as reproduction cost, as newer equipment may be able to do the same job cheaply
- Goodwill and intangible assets: These should strictly be valued at reproduction cost–how much of R&D and S&M spending will it take for a competitor to replicate the company’s competitive advantage? One of the variables in there should be how much sales is generated from an year’s worth of R&D, or S&M spend. This exercise would also capture any hidden value in company’s assets as internally developed R&D and relationships with suppliers and customers will be captured in this exercise.
I think what is missing here is an appropriate valuation of the offsetting liabilities (including the ones that don’t show up on the balance sheet). Offsetting liabilities that one assumes that the company needs to take on to bring itself to steady-state operations (e.g. higher capes to address underinvested PP&E) don’t often show up on the B/S and will need to be addressed as well.
Earnings Power Value (EPV): The good thing of having done the asset valuation is when we come to this stage, an easy question can be asked–what is the market value of the company when compared to its assets? If it’s, let’s say 2x that of the asset value, any competitor would think that they need to spend $x to get a valuation of $2x, and they would drive down the value of the company in question. The quest for the EPV will hopefully provide an answer to this question. EPV = E / R where E is the earnings power i.e. the distributable cash-flow that can be earned for foreseeable future without any growth but leaving the current operations intact, and R is the current cost of capital.
Distributable earnings can be calculated as follows –
- Remove true one-time charges (if there are repeatable one-time charges for A/R and inventory, see if these will keep recurring; for others for which it’s hard to estimate, perhaps it is best to take an average over the past business cycle).
- Resolve discrepancies between depreciation and amortization, and the actual amount of reinvestment needed. We are really looking at maintenance capex here–historically reported capex minus the growth capex. Companies generally have a stable Sales / Net PP&E ratio, which can help identify how much of the historically reported capex is growth capex.
- Undo effects of the current state of the business cycle to get a normalized number
- Add back the effect of less R&D and S&M spend given the spend is only for maintenance. This is a difficult estimate to make, but nonetheless few simple guidelines, for R&D, say, are (a)assume xx% of capex is maintenance capex (perhaps management mentioned it in a conference or a call, (b) capitalize past R&D expenses into an asset and try to estimate the resultant R&D asset/sales ratio and estimate the normalized R&D expense assuming no sales growth, or (c) look at what the competitor(s) are spending and what the company need to spend to remain relevant.
EPV should roughly be equal to the asset value in industries where there are no competitive advantage. If EPV is less than reproduction cost of the assets, then that means that the assets are being mismanaged, or the industry is being oversupplied. If EPV is greater, then we have latched on to the possibility of franchise value (= EPV – asset value).
Reconciling franchise value
- If we do see franchise value, it is worth calculating what the picture looks like from a new entrant’s perspective. We need to imagine that there’s a capital allocator sitting out there, and is doing analysis on getting in the industry. The return on capital that this new entrant can get will drive the economics of the existing firm. This analysis will make assumptions on what market share the new entrant will garner, what cost structure and spending will it manage once it makes an entry.
- Another angle to look at this, is to estimate the franchise margin, which is Operating earnings – (cost of capital x operating assets). If it is in the 5-8% range, perhaps it is sustainable. It is looks too high, perhaps we are estimating something incorrectly, or it will likely face significant competition to take advantage of this excess margin.
Franchises are very very powerful. As Warren Buffett said, economic franchise arise when product (a)is needed/desired, (b) doesn’t have a close substitute and (c) is not subject to regulation. Inept managers may diminish a franchise’s profitability, but cannot damage the franchise itself. In contrast, a “business” earns exceptional profits only if it is the lowest cost operator or service is tight, because the tightness in supply doesn’t last long. Unlike franchises, businesses can be killed by poor management.
Value of growth: This can be thought of as the optionality present in the valuation (assuming that the value investor is not looking at a company, where valuation is heavily contingent in future growth). Growth creates value only if the reinvestment rate doesn’t overwhelm the rate of return, once adjusted for cost of capital. Mostly, growth creates value only when the growth is within the company’s franchise (field of expertise) and benefits from competitive advantage.
For this calculation, we calculate the return on incremental capital and cost of capital, and see how growth affects the value of the growth component of company. The wider the difference, the more impact does the growth have on the company. PV of this component is Invested Capital x (RoC – g) / (k-g), which of course assumes that the RoC, k and g will presist, but this is a way to handicap the first iteration of the value of the growth. The biggest assumption here is that the franchise is durable.
BUT, the biggest value of this approach vs. DCF approach is that (a) the biggest chunk of value of the enterprise does not lie in the terminal value, and (b) the growth is used as an option, and not as the bedrock of the value.
Part III – Value Investing in Practice
- A CEO whose company annually retains earnings worth 10% of its net worth, after 10 years on job, would be responsible for 60% of all the capital at work in the business – Warren Buffett
- Institutional imperative is something where (a) projects will show up to soak up excess cash, and (b) projects will be copied across companies. – Warren Buffett
- Glenn Greenberg is not willing to pursue something in which he’s no comfortable putting 10% of the fund in
- Glenn Greenberg liked duopolies as they do not compete heavily on margins, so RoIC is more sustainable
- Paul Sonkin invests in broken IPOs. He also runs two portfolios–one is General Portfolio Ops, which has the usual stocks, and second is Arbitrage, where prices will be dictated by some event (presumably uncorrelated with the overall economy).