Value Investing From Graham To Buffett And Beyond by Bruce Greenwald

Summary

A good beginner book on value investing. The first half covers valuation and investment principles; the second half covers multiple value investors and their different styles. 

Key Takeaways

• Over the 60-odd years for which we have a detailed history of company fundamentals and share prices, betting on smaller companies has paid off.
• A three-element approach to valuation:
  • Assets
    • Liquidation value – Graham and Dodd
    • Book value
    • Reproduction cost
  • Earnings Power 
  • Profitable Growth
• As long as the return on capital and the cost of capital are the same, growth never – no matter how fast or slow – adds value to the business.
• Growth within the franchise creates value. Growth at a competitive disadvantage destroys value. Growth on a level playing field has no effect on value.
• If the market is overvalued, it is a good time to hold cash, the risk-free asset, and wait until opportunities reappear.
• Good businesses: operations with strong franchises, above-average returns on equity, a relatively small need for capital investment, and the capacity therefore to throw off cash.
• An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation.
• Private Market Value (PMV): the value an informed industrialist would pay to purchase assets with similar characteristics. PMV equals intrinsic value plus a premium for control.
• New information requires new valuations, and a company that looks fully valued in January can become a bargain by June.

What I got out of it

Having binge-read investment books for two months straight, I felt this book was too long-winded at first; weaker than most other value investment primers on second thought.

Going through my notes a third time, however, I actually think this is one of the better beginner books for value investing. 

The first half covers all the investment principles and valuation techniques you need to get started; the second half covers various long-standing value investors with differing styles. As a result, I think it covers everything you need to get started with value investing and find a mentor or style that suits you.

I still think it’s long-winded and could be cut short; I also don’t think the chapter on growth stocks is any good. Sticking with the first edition of the book – even if outdated – might be a safer bet for a beginner.

Summary Notes

Value Investing

Value investing rests on three characteristics of financial markets:

1. The prices of financial securities are subject to significant and capricious movements. Mr. Market, Graham’s famous personification of the impersonal forces that determine the price of securities at any moment, shows up every day to buy or sell any financial asset.
2. Despite these gyrations in the market prices of financial assets, many of them do not have underlying or fundamental economic values that are relatively stable and that can be measured with reasonable accuracy by a diligent and discipline investor.
3. A strategy of buying only when their market prices are significantly below the calculated intrinsic value will produce superior returns in the long run.
   The ‘margin of safety’: ideally the gap should be about one-half, and not less than one-third, of the fundamental value.

A value investor estimates the fundamental value of a financial security and compares that value to the current price Mr. Market is offering for it. If price is lower than value by a sufficient margin of safety, the value investor buys the security.

Value investors have relied on a three-phase process to direct their work:

1. A search strategy to locate potentially rich areas in which value investments may be located.
2. An approach to valuation that is powerful and flexible enough to recognize value in different guises, while still protecting the investor from succumbing to euphoria and other delusions.
3. A strategy for constructing an investment portfolio that reduces risk and serves as a check on individual security selection.

Value investing is an intellectual discipline, but it may be that the qualities essential for success are less mental than temperamental. 

1. A value investor has to be aware of the limits of his or her competence. You have to know what you know and be able to distinguish genuine understanding from mere general competence.
2. Value investing demands patience. You have to wait for Mr. Market to offer you a bargain. Fortunately, you are not compelled to act until that bargain is available.

Sitting still need not mean doing nothing. What does a value investor do when he or she cannot find securities that meet the dual criteria of falling within his or her circle of competence and being priced low enough to permit an adequate margin of safety?

Searching For Value

There is one other factor about a company that has had a major effect on the rate of return that investors would earn from owning its shares: market capitalization.

The stocks of small companies, measured by market capitalization, have outperformed the shares of large companies even when the price-to-book ratios are similar. Size matters, and smaller has been better most of the time. But not always: there have been periods when large capitalization stocks have outperformed the small fry. But over the 60-odd years for which we have a detailed history of company fundamentals and share prices, betting on smaller companies has paid off.

Why the value anomaly might persist in the face of intelligent and energetic investors who are trying to outperform the market averages? The answer, in a word, is biases. Investors, both as individuals and institutions, are in the grip of systematic biases that induce them to pay too much for winners and too little for losers.

The shares of companies too small for big funds are always available for sale.

Spin-offs are a wonderful opportunity for investors who are not constrained by questions of corporate size. Because many of the shares are sold for reasons unrelated to the company’s prospects, there are bound to be gems tossed away by the large funds for whom a small company stock, though perhaps a jewel, is still a nuisance. Spin-offs intensify the small company bias.

Other hunting grounds:

• Obscure securities. They tend to be the stock of smaller companies.
• Companies spun off from larger firms.
• Boring companies make for boring stocks and lower levels of interest.
• Companies in bankruptcy or suffering from severe financial distress.
• Companies in industries that suffer from overcapacity, a sudden increase in imports, general decline, or the threat of legislative or regulatory punishment.
• There is nothing more depressing than protracted underperformance.

Indicators of undesirability identify potential areas of opportunity; as investors flee from bad news or poor performance, they discard stock at prices that may exaggerate the company’s distress. These opportunities await the value investor with the knowledge and time to disaggregate the company’s results and spot the earnings potential; and a catalyst.

Valuation In Principle, Valuation In Practice

The standard way of calculating present values, and hence intrinsic value, is to begin by estimating the relevant cash flows for the current and future years out to a reasonable date, perhaps 10 years in the future. Then one selects (estimates) a rate for the cost of capital that is appropriate to the riskiness of the asset in question. With these two figures it is possible to calculate the present value of each annual cash flow; summing them gives us the present value of all the cash flows for the years in question.

The customary practice for dealing with the cash flows in the distant future is to come up with a terminal value.

A three-element approach to valuation:

1. Assets – Begin with the balance sheet and examine the value of the company’s assets. These accounting values are going to be more accurate for some assets than for others. We accept or adjust the stated numbers as experience and analysis dictate.
2. Earnings Power – To transform current earnings into an intrinsic value for the firm requires us to make assumptions both about the relationship between present and future earnings and about the cost of capital. because we need to rely on these assumptions, intrinsic value estimates based on earnings are inherently less reliable than estimates based on assets.
   1. Assumption 1: current earnings, properly adjusted, correspond to sustainable levels of distributable cash flow.
   2. Assumption 2: the earnings level remains constant for the indefinite future.
   3. Earnings Power Value (EPV) = Adjusted Earnings x 1/R. R = current cost of capital. Growth rate = 0.
   4. The intrinsic value of a firm is either the reproduction costs of the assets, which should equal EPV, or those assets plus the competitive advantages of the firm that underlie its business.
3. Profitable Growth.

Valuing The Assets

The investor has to make judgments about the reliability of the information and the strategic situation of both firms and industry in order to make accurate calculations of the value of the assets.

The strategic judgments concern the future economic viability of the industry in which the firm operates. 

• If the industry is in serious decline, then the asset values of the company should be estimated based on what they will bring in liquidation. 
• If the industry is stable or growing, assets should be valued at their reproduction cost.

The reliability issue is largely a question of how far down the balance sheet the investor chooses to go.

Opportunities lie in the gap between value and price.

Property, plant, and equipment, generally stated as net of accumulated depreciation, are the largest noncurrent assets for most companies. Though listed together on one line in the balance sheet, they are distinct from one another in the manner and degree to which their reproduction cost may deviate from book value. Property as land does not depreciate. Depending on one of the three cardinal rules of real estate (i.e. location), the land may be worth a lot more than is indicated on the books.

The depreciation rules by which the company reduces the value of its plant may bear only the slightest resemblance to what is actually happening to the economic value of the asset. Inflation can warp the values just as radically.

The adjustments made to equipment require a case-by-case analysis, which in turn depends on specific knowledge of the firm and the industry. The adjustment made to the equipment account, like that for plant, may be up or down, but it is not so likely to be massive.

To the question “Is goodwill worth anything?” the answer is that it all depends on the source of the goodwill, and for that we need information and industry knowledge.

How many years worth of R&D spending would the new entrant have to invest to reproduce the value that these firms have already created? That depends on how long a product keeps generating sales for the company.

Developing customer relationships also costs money – money that never appears as an asset. Although this information may be difficult for outsiders to obtain, a well-run company knows how long it takes to woo a new customer before an initial sale is made.

The amount it needs to spend depends on the sales cycle: how many months of selling, general, and administrative expenses the company has to pay out before it starts to take orders and make sales. It also needs time to develop the internal systems that allow it to function. So we need to add some multiple of the selling, general, and administrative line, in most cases between one and three years’ worth, to the reproduction cost of the assets.

There are other potentially valuable assets that may not be fully recognized on the company’s financial statements.

The surest method for assigning a value to the license or franchise is to see what similar rights have sold for in the private market, that is, to a knowledgeable buyer who is paying for the whole business.

If our task is to determine the value of a company based on the reproduction costs of its assets, we really want to know how much money an investor or business person would have to lay out to acquire or replicate those assets.

It is useful to think of liabilities as falling into three categories:

• Those liabilities that arise intrinsically from the normal conduct of the business: accounts payable to suppliers, accrued vacation and other wage costs due to employees, accrued taxes due to governments, and other accrued expenses.
• Those obligations that arise from past circumstances that are not pertinent to a new entrant. For example: deferred tax liabilities or liabilities incurred because of adverse legal judgments are probably not relevant for the newcomer.
• Outstanding formal debt of the company. The appropriate treatment is a matter of choice. We use the market value of the debt, if available; if not, the book value is generally an adequate alternative.

The other way to treat debt is to consider it alongside equity as part of the investment in the company. Using what is called the enterprise value approach, we add the market value of the debt to the market value of the equity and then subtract cash. This is the enterprise value.

Reproduction costs are one of three methods used to establish an asset-based valuation of a company. The other two are Graham and Dodd’s and Book Value.

An asset valuation based on reproduction costs provides an accurate estimate of what the company might be worth, as demonstrated by the arrival of a willing buyer to purchase it for roughly that amount. But – and this is a second moral – it generally requires more than analysis to levitate depressed asset values off the floor, namely, some catalyst to upset the status quo and propel a change.

Earnings Power Value

It doesn’t matter whether the toaster is a commodity and sells only on price or it is a differentiated product and sells on features. Ultimately, new entrants will appear until the EPV comes to equal the asset value. This equality is not an accident; it is a fundamental economic connection, and it results from the corrosive influence of competition on prices and profit margins.

These three concepts – franchises, barriers to entry, and incumbent competitive advantages – amount to the same thing. They are the major sources, in a modern market economy, of any value that exceeds the cost of reproducing a firm’s assets.

Firms with captive customers should work to enhance their ties in the following ways:

• By raising switching costs through adding features and services to the original offering, which has been a Microsoft strategy.
• By reinforcing habits through increasing frequency of purchases due to obsolescence or with leasing plans for automobiles.
• By raising search costs through extending and complicating the offered range of services and enhancing existing customer satisfaction.

At the same time, companies benefiting from these competitive advantages should exploit them with aggressive pricing strategies and raise prices whenever they can.

Cost advantages based on superior production systems survive only as long as the underlying technology. Rapid change in technology will often mean that, in the absence of economies of scale, cost structure advantages are very short-lived. On the other hand, even if the technologies are long-lasting, patents do expire, learning curves flatten, and the associated competitive advantages still disappear.

Inside Intel

Without any competitive advantage, a company’s earnings are equal to its cost of capital multiplied by its operating assets. We will call this amount free-entry earnings, indicating no special advantage.

Present Value / Earnings Power Value = Margin of Safety

Value created by growth depends on two factors:

• Profitability of the incremental capital employed. The greater the amount by which incremental returns exceed the cost of capital, the greater will be the value created by each dollar invested. This is expressed as Return on Capital / Cost of Capital.
• The amount of capital that can be employed to earn these franchise returns. That depends on how fast the franchise grows. The limits of sustainable growth are some fraction of the cost of capital.

As long as the return on capital and the cost of capital are the same, growth never – no matter how fast or slow – adds value to the business.

Growth within the franchise creates value. Growth at a competitive disadvantage destroys value. Growth on a level playing field has no effect on value.

Constructing The Portfolio

1. Value investors operate within the boundaries of their competence. They only select what they understand and their preferences are for companies that can be reliably valued, with stable positions, a history of steady earnings, and businesses that are not vulnerable to sudden changes in technology or consumer taste. If these requirements exclude value investors from owning the alluring growth names in technology or other industries undergoing transformation, that is a restriction they willingly accept.
2. The margin of safety requirement provides a mechanism for substantially less than tangible book value or the well-tested value of its earnings is already a low-risk strategy. using a valuation based on assets as a check on a valuation based on earnings power, all the while refusing to pay much if anything for the prospects of growth, further limits risk.

If we think of risk as avoiding permanent loss of capital, then stock selection using the principles of valuation we have discussed, including the margin of safety, may be more important than diversification so extensive that nothing other than volatility is left as a source of return.

Value managers are sometimes faced with the decision about what to do with the funds entrusted to them when they can find no more suitable places to put their money. In the worst case, the markets may be so extremely overpriced that there are no identifiable value opportunities.

If the market is overvalued, it is a good time to hold cash, the risk-free asset, and wait until opportunities reappear.

Value Investing In Practice

Warren Buffett

Good businesses: operations with strong franchises, above-average returns on equity, a relatively small need for capital investment, and the capacity therefore to throw off cash.

“We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favourable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.” – Warren Buffett

The investment shown by the discounted cash flow (DCF) model to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.

The real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.

The primary factors bearing upon this evaluation are:

1. The certainty with which the long-term economic characteristics of the business can be evaluated.
2. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows.
3. The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself.
4. The purchase price of the business.
5. The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing power return is reduced from his gross return.

The empire would have been larger, but the citizenry would have been poorer.

Time is the friend of the wonderful business, the enemy of the mediocre.

We wouldn’t have liked those 99:1 odds – and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns.

The importance of being in businesses where tailwinds prevail rather than headwinds.

While first-class newspapers make excellent profits, the profits of third-rate papers are as good or better – as long as either class of paper is dominant within its community.

Once dominant, the newspaper itself, not the marketplace, determines just how good or how bad the paper will be. Good or bad, it will prosper. That is not true of most businesses: inferior quality generally produces inferior economics. But even a poor newspaper is a bargain to most citizens simply because of its “bulletin board” value. Other things being equal, a poor product will not achieve quite the level of readership achieved by a first-class product. A poor product, however, will still remain essential to most citizens, and what commands their attention will command the attention of advertisers.

The reason media businesses have been so outstanding in the past was not physical growth, but rather the unusual pricing power that most participants wielded. Now, however, advertising dollars are growing slowly. Most important of all, the number of both print and electronic advertising channels has substantially increased. As a consequence, advertising dollars are more widely dispersed and the pricing power of ad vendors has diminished.

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation.

We remained in the business for reasons that I stated in the 1978 annual report: (1) our textile businesses are very important employers in their communities, (2) management has been straightforward in reporting on problems and energetic in attacking them, (3) labour has been cooperative and understanding in facing our common problems, and (4) the business should average modest cash returns relative to investments.

I won’t close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable.

“Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.” – Warren Buffett

Mario Gabelli

Private Market Value (PMV): the value an informed industrialist would pay to purchase assets with similar characteristics.

PMV equals intrinsic value plus a premium for control.

PMV moves beyond financial data and focuses on operating statistics.

PMV as an investment strategy entails the recognition that it takes something – an event, a person, a change in perception – to narrow the spread between the market price and PMV. This is called a catalyst.

There are two kinds of catalysts: specific and environmental. 

• Specific catalysts are those changes, either anticipated or recently occurring, that alter the prospects of a particular company. Examples: financial or operational restructurings, spin-offs, share repurchases, a change in management, and investments in new business developments.
• Environmental catalysts are disruptive shifts in the world in which businesses operate. Not only global warming but also changes in the political, social and economic climates.
  • In many instances, the environment in question is the government, in its legislative, administrative, and regulatory roles.
  • Other environment catalysts emerge as the consequence of disruptive shifts in technology that facilitate the reorganization of whole industries.
  • Consolidation is one result of many of these environmental catalysts.

Glenn Greenberg

They – Greenberg’s funds’ partners – need to have two types of confidence in the selection:

• Confidence in their ability to understand the company, its industry, and its business prospects.
• Confidence in the company, that it will continue to perform well and increase the wealth of its shareholders.

They want to buy “good” businesses, by which they mean those that are unchallenged by new entrants, have growing earnings, are not vulnerable to being technologically undermined, and can generate enough free cash flow on a regular basis to make the shareholders happy, either through dividends, share repurchase, or intelligent reinvestment.

Greenberg subjects every investment to an “Internet test,” trying to anticipate how its business might be affected by this new and disruptive technology.

The discounted cash flow approach requires that all crucial assumptions about the future, such as rates of production or the price of energy, be made explicit. It is a guard against speculation.

Seth Klarman

For Klarman, it would be more accurate to say margins of safety. The securities he likes to buy are cheap on a host of measures: price to book value, price to earnings, price to cash flow, break-up value, dividend yield, and private market value. He also evaluates objective factors such as insider buying, corporate share repurchases, and the like.

Klarman is most comfortable when the belt of asset value is reinforced by the suspenders of earnings.

Klarman examines the risks – by which he means the likelihood and magnitude of possible losses – of any investment before he starts to think about the returns.

The feature on which he places most emphasis is what might be called a motivated seller, someone who is selling for a noneconomic reason.

When assets are sold for noneconomic reasons, the most common explanation is that some type of institutional constraint obliged the owner to move. Examples in which this occurs:

• Spin-offs
• Bankruptcy filings
• Real property in the wrong hands

The other side of the motivated seller advantage is a situation in which there are only a few other buyers considering the same asset for purchase.

A rate of return only makes sense when set against the risk involved.

Michael Price

Lower the risk first, and higher returns will follow.

If you don’t do too badly during the down years, you only have to perform decently during the up years to beat the averages over time.

To estimate the intrinsic value of a firm, Price asks one question: How much is a knowledgeable buyer willing to pay for the whole company?

Study the mergers and acquisitions transactions in which companies are bought and sold. Every transaction produces voluminous documents in which the parties to the transaction spell out in detail the basis for the price that is agreed upon: How much is being paid for each revenue stream that makes up the company being acquired?
Because each large company operates in more than one line of business, the knowledge has to be organized on a business-segment basis.

Price does not rule out more traditional approaches to valuation: reproduction costs of assets, how much they are insured for, multiples of cash flow, and even book value. But he uses these as checks on the transactions-based valuations that he assembles from studying the market for control. His preference for the deal-based valuation is that it is current, that it incorporates the informed buyer’s valuation of the business, and that it includes a premium for control that may be worth a lot to the share owner who finds that his or her investment is now in play.

Price’s definition of a cheap stock is one that is selling at 40 percent below his estimate of its intrinsic value.

Early in the bankruptcy process, before anyone can predict the outcome with certainty, it is much safer to hold senior debt. Price’s rule is to buy it only after the price has fallen 30 percent or 40 percent of what the enterprise is worth.

There are four main stages in most bankruptcies:

1. Before the filing, when the company may be trying to get creditors to agree on a solution (meaning that creditors will accept less than the face value of the debt they own in exchange for a speedier and more certain outcome) or to attract new capital.
2. The filing itself, either with this solution in hand (known in the trade as a prepack) or not.
3. The reorganization plan is offered first by the firm in bankruptcy and then negotiated with hand among the various creditors until an agreement is reached.
4. Emergence of the firm from bankruptcy, with a new capital structure and new securities issued to claimants.

The connecting thread through all the stages of bankruptcy and the various ways of profiting from an investment is knowledge: knowledge about the company and its intrinsic value of its assets, knowledge about the classes of debt and the assets backing them, knowledge about the bankruptcy process and the ways in which creditors can influence decisions, and knowledge about the conditions of the new company and its underlying value. The more knowledgeable the better, and the earlier an investor can figure out what is likely to happen, the greater the payoff.

Four attributes that define Price’s approach to investing:

• Discipline. Don’t alter the policy you have established for the composition of the portfolio just because other approaches are currently more favoured. 
• Patience
• Focus
• Do your homework

Walter And Edwin Schloss

The Schloss father-son duo starts by looking at the balance sheet. Can they buy the company for less than the value of the assets, net of all debt? If so, the stock is a candidate for purchase.

One of Graham’s favourite teaching strategies was to analyze two companies side by side, even if they were in different industries, and compare the balance sheets. Then ask which stock was more of a bargain relative to the net asset values. Graham’s primary concern was the margin of safety, a focus which prevented him from recognizing the great growth potential of Coke.

A company’s assets are more stable than its earnings.

In Schloss’ long experience, companies whose shares can be bought for less than the value of the assets will, more often than not, either return to profitability or be taken over by another firm. All of this may take time; their average holding period for a stock is around four years.

Financial statements are important, but so are the footnotes. 

• Be certain that there are no significant off-balance sheet liabilities. 
• Look at the history of capital spending to see what condition the fixed assets are in.
• Look for recovery potential.

Having started with a bottom-up approach to finding a cheap stock, now that they own it they look laterally to analyze other firms in the industry. Are these also cheap, and for the same reasons?

Warren Buffett didn’t say it but some of his investments – Coca-Cola, See’s Candies, Dairy Queen – suggest faith in the notion that no one ever went broke selling sugar to Americans.

Paul D. Sonkin

Sonkin loves to spot situations like the following:
Say the firm has a market capitalization of $20 million with earnings of $1 million. Ordinarily, this looks like a price per earnings (P/E) ratio of 20, and in most cases the stock is no bargain. But if the company has $15 million of net cash, then the whole company can be bought for an outlay of $5 million. The real P/E is closer to 5 and the stock becomes a screaming buy.

Sonkin uses the cap rate, short for capitalization rate. The denominator in a cap rate equation is the market value of the debt plus the market value of the equity minus the cash or cash equivalents. The numerator is the operating earnings (EBIT) times (1 – tax rate). The purpose is to expose what an investor would have to pay to own all the after-tax operating earnings of the company. The cap rate analysis is a starting point for Sonkin, a kind of screening test to see if the company merits further work.

Small companies are much easier to understand. Both their financial statements and their business models tend to be simple. They probably have a few competitors and a few major customers. It takes almost no time to make the phone calls that analysts rely on to feel comfortable about the business. Put in economic terms, the marginal value of time spent studying a small company far exceeds that spent on a large one.

New information requires new valuations, and a company that looks fully valued in January can become a bargain by June.