little book final

7/27/2019 Little Book FINAL

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The Great Little

eBook on Value

Investing


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Value Investing: A Snapshot

Value investing is often called the holy grail of investing success. It is highly regarded as an

investment philosophy, having been used by investment gurus such as Benjamin Graham,

Warren Buffet, Seth Klarman and Christopher Browne. The philosophy has enabled these

investors to outperform the market by a wide margin over long periods of time.

If you were to explain value investing to a fifteen year old, this is probably how you would do it:

Finding companies where what the market thinks they're worth is substantially different from

what they are really worth, and then investing in them in order to make a profit.


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To put it very simply, those 29 words are at the heart of the value investment philosophy. It is the

difference between value andprice that drives the rewards from implementing the principles of

value investing.

Think of value andprice in terms of the solar system.

The value of company is the sun, and the prices that the market gives the company at various

points in time are like the planets which revolve around the sun. Sometimes, the planets are in

front of the sun, and sometimes they are behind the sun. This is akin to the price being above

value at times, and below value at other times. The trick is to invest in the company when price

and value are farthest from each other.

Value investing is more an art than a science. Which means that with diligence and daily

practice, anyone can get better at it. A major aspect of value investing is that it is a philosophy, a

way of thinking about how the investment world works. Therefore, in order to be able to

implement it to make investments, the first step is to believe in this philosophy. The following

beliefs are at the core of this philosophy:

Markets are NOT efficient: The efficient market hypothesis might have won the Nobel Prize,

but if it held true all the time, then the asset management industry wouldn't be worth trillions of

dollars. Markets go crazy, and they go crazy as often as you and me. This happens because

investors and other market participants, as a whole, are irrational. Sometimes markets overreact

to news, events and situations, and at other times they hardly react at all. I don't have intentions

of rewriting economic theory. But avenues to profit from investments arise primarily because

markets are inefficient a lot of the time.


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Contrarian is good: Value investing often requires you to challenge conventional wisdom, go

against the wind and stand apart from the crowd. This means that very often you will be moving

in the opposite direction of everybody else. Which can be terrifying at times. It requires that you

make decisions which others will mock you for. And to stick by those decisions during good

times and bad requires discipline. You can often expect to get caught up in competing thoughts

such as the one below. But with the results that value investing can bring, you will never want to

abandon the philosophy.

"I can't afford to miss a rally, but I sure can't afford to get killed if things go in the other

direction because none of this is real"

Mindset is everything: This philosophy is as much about mindset as it is about anything else.

The mindset required by the philosophy is that investing is serious business, not a game that you

play for a few hours a day. Success in anything requires discipline, dedication and hard work.

Value investing is no different. To become a successful value investor, you have to adopt the

mindset of a successful investor, not a speculator or a day trader. Value investing requires

emotional discipline, and value investors require a sound intellectual framework to be able to

apply its principles.

Every company has a value and a price: Value investing requires that you invest based on

price AND value, not just price. In other words, every company has a market price, which differs

markedly from underlying value at various points in the business cycle. Investments should be

made using price AND value as analytical foci. A low price alone does not justify a sound

investment. If value is low, and this is reflected in price, but you don't make an effort to estimate

value, then putting your money into a stock at a low price will only result in your money being

invested in a stock that is going nowhere. So the investment process always consists of

comparing price and value in order to make investment decisions.


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Assessing Value: A 7 Step Process

The worth of an equity holding in a company is determined by its share price. So in the value

investing equation, one variable is readily available at any point in time.

The tricky bit of the equation is to estimate value. Value estimation involves not only the number

crunching of figures in the financial statements, but making a detailed inquiry into the non-

quantitative aspects of a business.

In this section, I provide a basic overview of the 7 steps every value investor needs to adhere to

in coming up with an estimation of value for any company.

1. Quality of Business

The quality of a business can be assessed in lots of different ways. In value investing terms

however, we're talking about the historical patterns that have emerged in the last few years that

the company has been in existence.

There are a few key financial metrics that you need to look at when assessing the quality of acompany's business:

Free Cash Flow: As any valuation text book will tell you, this is the amount of cash that a

company generates every year from its operations. 'Cash is king'. But how that cash flows is

crucial to judging the success of a company. As an investor, your primary concern is the amount

of cash that a business generates. To get an idea of how a business is performing, analyze FCF

for the last 5 to 7 years to get a feel for the average growth rate in FCF. A company that has a

FCF average growth rate of 20% or more is performing very well indeed.

EBIT: Earnings before interest and tax are a good indicator of the value being produced from

operations. Although this figure does not provide a very good indicator of performance for

highly leveraged companies, it is a key performance metric that must be analyzed. Growth rate in

EBIT will provide clues about the sustainability of earnings. EBIT growth and FCF growth tend


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to move in tandem, and when they don't you know you need to delve deeper to understand the

cause for this. EBIT margins for the years under analysis should be fairly steady. A volatile

EBIT margin indicates that the company does not have control over either its revenue streams or

its cost base.

Crown jewels and diversification: One needs to ascertain if the company relies on a 'crown

jewel' to produce most of its revenues or profits. If a company is over-reliant on a crown jewel(s)

for revenues or profits, then the question that needs to be asked is 'How long is this sustainable?'

Most companies that are over-reliant on a single division for revenue or profits will be seen to be

diversifying their revenue streams. Is EBIT fairly evenly spread across business segments?

Beware of companies that are not making an attempt to diversify.

Dividend Yield: The annual dividend is one of the most important signaling tools in the hands of

management. Fluctuations in dividend yield that come about as a result of changes in the

numerator should warn you of changes in the quality of the business. Very often managers aim to

keep a stable dividend yield even in years of poor performance. Take the recent case of Tesco,

the UK's largest supermarket chain. EPS dropped to just about 1.5 pence per share, but the

Management chose to maintain the dividend at the preceding three year average of 13 pence per

share. This calls for closer scrutiny of Tesco's dividend announcements in the upcoming quarters.

Other financial metrics: Return on Capital Employed (ROIC), FCF Yield and leverage are

other key metrics that need to be monitored closely. Trends in these ratios provide useful

information about changes in financing structure, and very often about the performance of

management. Volatile changes in any of these metrics needs to be investigated, as the cause of

volatility can often be the deciding factor in an investment.

2. Valuation

Valuation is imprecise. Valuation is complex. Very often, analysts and investors allow

themselves to spend too much time on trying to give a business an accurate valuation. The fact is

that a valuation can only be as accurate as the accounting numbers that it is based on. There are


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plenty of ways that a company can depict its position under the current accounting standards,

especially those that report under IFRS. The depiction that one sees in the annual reports is one

scenario out of potentially many.

As David Dodd eloquently put it in Security Analysis:

"The essential point is that security analysis does not seek to determine exactly what is the

intrinsic value of a given security. It needs only to establish that the value is adequate - e.g., to

protect a bond or to justify a stock purchase - or else that the value is considerably higher or

lower than the market price. For such purposes an indefinite and approximate measure of the

intrinsic value may be sufficient."

The valuation of a company has to be carried out on 3 levels to give you a good picture of where

the company stands in the value vs.price equation.

Standalone valuation: A standalone valuation is an estimate of the value of the company based

on best estimates of growth rates and margins in the future. A Discounted Cash Flow (DCF)

model is usually constructed so as to project the financials of the company indefinitely into the

future. Since projections are always based on assumptions, such models are highly sensitive to

the assumptions on which they are based. In any case, the point here is to get an idea of how the

assumptions in the model (including the discount rate) need to be adjusted to get to the price that

the company has in the stock market. If obtaining a value close to the market price involves

unreasonable assumptions about growth rates, margins or discount rates, then you know you

potentially have a value opportunity on your hands (or not!).

Relative valuation: A relative valuation is carried out to see where the company stands in

relation to competitors and other companies with similar business models. The comparison is not

done in terms of a specific value, but more so in terms of the following ratios:

- Net Debt/ EBITDA

- Price to Earnings

- FCF Yield

- Enterprise value/(Equity - Cash)


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- EBIT Margin

- EBIT Growth yoy

Such a relative valuation gives the investor a good snapshot of where the company stands on a

number of metrics. Be careful not to compare too many metrics as this will just confuse you.

Pick appropriate metrics based on the company that you are analyzing. The aim is to aid the

decision-making process, not complicate it. Industry averages for most of the above ratios are

available. If you have access to a Bloomberg terminal, you should have no problem in getting

this information. If you don't, seek out sell side analyst reports, as these invariably have all

industry related information.

Historical valuation: The last bit of work you will need to do on valuation is to analyze two key

ratios on a historical basis. These are the price to earnings ratio and the EBIT margin (or any

other operating profit margin applicable to the company that you are studying). Analyzing the

historical trend of these two ratios should give you a good picture of how the P/E has trended in

relation to the performance of the business over time. If the P/E is on the lower end of the long

term average, while margins are trending upwards, there is a good chance you have found a stock

that is not on the radar of the market and a possible value investment opportunity.


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Putting it all together - Now that you have a good idea of the value of the company, you need to

make estimates of a range of possible values that the share price can take over your investing

horizon. An example calculation that you might conduct for your stock might look something

like this:

Where,

The implied share price is??? ??? ????

??? ????? ????? ?????, and the FCF (Down, Base and Up) are estimates

of what you have obtained from company and market sources,

P/L % is the profit or loss % from investing at the current price. It is calculated based on the

current share price and the total net price under the three scenarios,

The probability weightings needn't be from a probability formula, they need to be your best-

guess probabilities for each scenario.

The base case scenario to down case scenario shows you how much you would gain if the base

case scenario played out vis--vis what you would lose if the down scenario played out. So in the

analysis above, you would make 3x the amount of money in the base case than you would lose in

the down case. Thinking in these terms can identify the attractiveness of multiple opportunities.

Central to the value investing philosophy is the concept of margin of safety. The margin of safety

principle means that investments must be purchased at a discount from their underlying value.

Current Share Price $15.00

Down Base Up

2012 FCF Per Share 1.33 1.5 1.84

FCF Yield Assumption 10.00% 7.50% 7.50%

Implied Share Price 13.30 20.00 24.53

Annual Dividend 0.15 0.15 0.15

Total Net Price 13.45 20.15 24.68

P/L% -10.3% 34.3% 64.6%

Probablity Weightings 25% 50% 25%

Probability Weighted Expected Return

Base Case : Down Case Ratio

2012 Implied EV/(E-C) 5.5 8.2 10.0

2012 Implied P/E* 10.0 13.3 13.3

*Assuming FCF/share equal to EPS

30.7%

3.32:1


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The thinking behind having this margin of safety is that when purchased at a discount to value,

investments have a higher probability of turning a profit than of making a loss. This means that

you are always making investments where even if your investment thesis is proved wrong, the

fall in price that you will suffer will be much less than if you purchased an investment without

this margin of safety.


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3. Catalysts

Catalysts are those events that eliminate the dependence on market forces to cause changes in the

share price of companies. When an investor puts money into a stock, there is always a chance

that a certain future event or decision will narrow the gap between value and price. Such

catalysts provide investors with a cushion, above and beyond that provided by the margin of

safety.

Catalysts can be internal as well as external. Internal catalysts are those that are at the discretion

of company management. Divestitures, liquidations, share buybacks and recapitalizations are all

internal catalysts that might cause the share price to move towards its true value. External

catalysts are those that arise due to forces outside the control of the company. Regulatory

changes in favor of the company, increased holdings of voting shares and competitors going out

of business are examples of external catalysts.

Not all investments will have catalysts associated with them. However, those investments that do

have catalysts associated with them are lower risk investments, as the successful realization of a

catalyst will serve to quicken the closure of the gap between value and price.

A word of caution: Although in most cases internal catalysts are expected to lead to positive

outcomes for share prices, one must tread carefully in assessing the impact of such catalysts on

total shareholder return. A replacement of dividends by share buybacks might lead to short term

increases in EPS and therefore return, but the long term implication of lowering dividends might

be to reduce total shareholder return. This is what happened in the case of International Business

Machines (IBM) between 1980 and 2003. So always be weary of companies that undertake share

buybacks on a frequent basis under the guise of increasing returns to shareholders.


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4. Management and smart holders

This refers to the quality of management, and to the holdings of management and other

institutional investors in the shares of a company.

The quality of management is often directly related to the success of a business. Changes in

management do not always lead to better results. With the vast amount of information available

on the internet, it is possible to get detailed information about managers and their past successes.

Despite changes in management, the fraction of the company held by management should not

fluctuate with every change in top personnel. Attitudes of new managers towards shareholders

can be judged from their actions in previous roles.

The holdings of management need to be monitored. Are the managers in charge of the business

increasing or decreasing their holdings? The ratio of cash and stock compensation is particularly

valuable. Companies which reward their managers with a greater share in the form of stock and

stock options are better aligning the interests of management and the shareholders.

As Seth Klarman put it in Margin of Safety, there are many reasons why an insider might sell

stock, but there is only one reason for buying. Keeping an eye on the stakes of managers and

owners is a good way to get into the minds of insiders on the future prospects of a company.

Smart holders and hedge funds, asset managers and other professional money managers who

make large investments in companies. Very often, these smart holders know about developments

in greater detail than can be garnered from public statements and reports.

It is possible to get details of institutional share ownership from a number of sources. Sell side

firms frequently report such data in their analyst reports. An increase in the number of smart

holders with a value bent might indicate that there is value in a particular opportunity. Two

examples are that of Newscorp Inc and Tesla Motors. In May 2011, it was reported that the share

of value investor share ownership in Newscorp Inc went up from 17% in 2010 to 44% in 2011.

Similarly, in October 2013, a BoFA report indicated that institutional share ownership of Tesla

Motors fell from 85% in January to under 60% in October, signifying that a lot of the increase in

share price in the intervening period could be attributed to retail investors rushing in. It must be


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kept in mind that such changes in ownership should not be given too much weight when sizing

up an investment opportunity.

5. Assessing the critical path

The critical path refers to the future direction of company strategy, and how this strategy is likely

to create or destroy value for shareholders. Management's discussions in quarterly and annual

reports and on calls with analysts will provide an insight into the key acquisitions, developments

in strategy and changes in direction that the company is likely to undergo in the future. Albeit

boring and cumbersome, insightful knowledge is often gained from reading the Form 10-K filed

by the company. As an investor, it is crucial to have an understanding of the future strategy ofthe company. Attention must be paid to any regulatory and/or legal changes that are likely to

affect the company adversely. The strategy of the company with respect to acquisitions can often

signal the management's confidence in deploying cash effectively.

Management often provides a description of the evolution of company strategy. One of the best

ways to judge whether a company is on track is to read past annual reports and see if the

strategies that have been made public in the past have been implemented.

6. Develop a monitoring plan

After you have conducted the analysis above, the next step is to decide on a plan of action to

monitor developments at the company. As an investor, it is inevitable that you will have a

number of companies on your watch list. From the management's discussion in the annual report,

you will be able to list out a plan to monitor future developments that have the ability to impact

the share price. These developments relate to future acquisitions and divestments, changes in

legal and regulatory regimes, and impending changes in management. You need to keep abreast

of developments with respect to your company, as these changes often can cause large swings in

price and diminish or amplify the attractiveness of an investment.


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7. Upcoming events

When a company is on your shortlist, you cannot afford to miss out on important announcementsand investor calls. Quarterly earnings reports, chairman's addresses to shareholders and other

announcements by the company have to be on your radar. Make a list of all such calls, meetings

and reports due in the next three to six months, and be sure to look out for subtle changes in the

stance that management takes with respect to strategic direction.


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Wrapping it Up

The central theme of this ebook is to give you a brief insight into the philosophy and method to

be followed to become a value investor. It draws from the wisdom and teachings of some of the

greatest value investors, past and present.

As you have probably gathered, value investing requires a lot of diligence, analysis and a

willingness to constantly refine one's investment knowledge. Having been present at talks,

meetings and conference calls with a number of successful investors in my short career to date,

one recurrent theme I have observed is that all successful investors have a repeatable process that

they bring to the table when analyzing potential investments. They never sit down to discuss

which way the market is headed; it is always about how they can improve the process ofsearching for and assessing potential opportunities. They are deliberate and consistent in what

they do. Having a repeatable process ensures that they are always learning - it is possible to make

money on a bad investment and lose money on a good investment.

While markets seem to have a mind and mood of their own, value investing necessitates a deep

desire to understand the fundamentals, and act accordingly. Quick money is not the goal, long

term investment success is.


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In any case, with the way the world is progressing, you are more likely to make quick money

starting, working for or investing in a tech start-up than you are investing in the financial

markets.

"One great irony of investing is that when fears subside and financial markets rise substantially,

investors should actually become more skeptical. Risks grow when prices rise ahead of

fundamentals. It is precisely at such times - when risk premia are shrinking - that investors cease

to be rewarded adequately for the incurrence of risk."

- Seth Klarman (Letter to LPs)

By: Ryan Chadha, @RyanChadha for ValueWalk

Also see his site: http://www.finbox.co

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