Sunday 15 January 2017

Business value cannot be precisely determined. Make use of ranges of values.

Business value cannot be precisely determined. 

 Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible. 

 Although anyone with a calculator or a spreadsheet can calculate a net present value of future cash flows, the precise values calculated are only as accurate as the underlying assumptions.

Investors should instead make use of ranges of values, and in some cases, of applying a base value. 

Ben Graham wrote:
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 considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.




There are only three ways to value a business. 

1.   The first method involves finding the net present value by discounting future cash flows. 

Problems with this method involve trying to predict future cash flows, and determining a discount rate. 

Investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.


2.  The second method is Private Market Value using Multiples. 

This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. 

The problems with this method are that comparables assume businesses are all equal, which they are not. 

Furthermore, exuberance can cause business people to make silly decisions. 

Therefore, basing your price on a price based on irrationality can lead to disaster. 

This is believed to be the least useful of the three valuation methods.


3.  Finally, liquidation value as a method of valuation. 

A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. 

Fixed assets can be difficult to value, as some thought must be given to how customised the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).





When should each method be employed? 

They can all be used simultaneously to triangulate towards a value. 

In some cases, however, one might place more confidence in one method over the others. 

For example, 
  • liquidation value would be more useful for a company with losses that trades below book value, while 
  • net present value is more useful for a company with stable cash flows.

Using the methods of valuation described, you can search for stocks that are trading at a severe discount; it is possible, their stock price more than doubled soon after.




Beware of these failures

The failures of relying on a company's earnings per share - too easily massaged.

The failure of relying on a company's book value  - not necessarily relevant to today's value.

The failure of relying on a company's dividend yield - incentives of management to make yields appear attractive at the expense of the company's future.



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Saturday 14 January 2017

Central elements to a Value Investing Philosophy

The three central elements to a value investing philosophy:

1) A "bottom-up" strategy
2) Absolute (as opposed to relative) performance
3) A risk averse approach



Bottom-Up Investing

Most institutional investors use a top-down approach to investing. 

  • That is, they try to forecast macroeconomic conditions, and then select investments based on that forecast. 
  • This method of investing is far too prone to error, and doesn't allow for a margin of safety.
  • For example, a top-down investor must be correct about the big picture, draw the correct conclusions from that big picture prediction, correctly apply those conclusions to attractive areas of investment, correctly specify specific securities, and finally, beat other investors to the punch who have made the same predictions.
  • In addition to these challenges, top-down investors are buying based on concepts, themes and trends. 
  • As such, there is no value element to their purchase decisions, and therefore they cannot buy with a margin of safety. 

On the other hand, bottom-up investors can apply a margin of safety and face a limited number of questions, e.g. what is the business worth, what is the downside etc.



Absolute Performance

Institutional investors are judged based on their performance relative to their peers or the market. 
  • This results in a short-term investing horizon.
  • Thus, if an investment opportunity appears undervalued but the value may not be recovered in the near-term, such investors may shun such an opportunity. 

Absolute investors don't judge themselves based on their performance to the market, which results in a short-term investing horizon. 
  • Instead, they focus on investments that are undervalued, and are willing to wait for that value to come uncovered.



Risk

In the financial industry, returns are expected to correlate with risk. 
  • That is, you cannot generate higher returns without taking more risk. 
  • Downside risk and upside potential are considered to have the same probability (an implication of using beta, a measure of a stock's volatility versus the market).

Value investors think of risk very differently. 
  • Downside risk and upside potential are not necessarily the same.
  • Value investors seek to exploit this key difference by buying stocks with strong upsides and limited downsides.


Read:
Seth Klarman - Margin of Safety




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The Philosophy of Value Investing and Why It Works

What is Value Investing?

 The terms used to describe value investing don't require any accounting or finance background.

Value investing is described as paying 50 cents for a business worth $1. 

Warren Buffett's analogy using the maximum allowable weight of a bridge is used to illustrate how this margin of safety works:

"When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing."




Margin of Safety (buying at a discount) is of utmost importance

What allows value investors to apply a margin of safety while most speculators and investors do not?

Again using a Buffett analogy to illustrate this:

A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.

Value investors do not buy businesses they do not understand, nor ones that they find risky. For example, they will avoid technology companies and commercial banks. 

Value investors will also invest where their securities are backed by tangible assets, to protect them from downside risk.

Because the future is unknown (e.g. a business worth $1 today might be worth 75 cents or $1.25 tomorrow), there is little to be gained by paying $1 for this business.

The margin of safety (buying at a discount) is therefore of utmost importance. 

Value investors gain an advantage when many:

  • do not buy with a margin of safety, 
  • remain fully invested at all times, and 
  • trade stocks like pieces of paper with little regard to the underlying asset values.






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Philosophy of value investing. Need to have clear strategies too.

Buffett's first two rules of value investing:

1) Don't Lose Money
2) Never Forget Rule #1

While it is easy to say these rules, by themselves they don't help investors. 

The future is uncertain. 

These are always unknown:
  • future GDP growth rates, 
  • inflation rates, and 
  • other relevant factors to stock price returns. 
Furthermore, stocks are junior securities to debt and other firm obligations, making their future values even more uncertain. 

Stocks are certainly not risk free.

The investors need to have clear strategies, which they can follow, that will help them follow the above rules of Buffett's.



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How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s

How the Wall street created the junk bond market investment fads?

In the early to mid-1980's, Wall Street firms pushed junk bonds on investors.

They touted the positive historical results of high-yield debt. 

There were major differences between the debts of fallen angels versus newly issued bonds from fragile companies.

Debt from fallen angels:

  •  trades at a discount to par, 
  • downside risk is reduced. 
  • at the same time, the potential for capital appreciation is large. 
Newly issued debt from marginal companies 

  • does not share in these above characteristics.


How Wall Street can create investment fads, only to leave investors much poorer when the tide goes out.

 That didn't stop Wall Street from pushing this form of debt (newly issued debt from marginal companies), nor did it stop investors from ponying up and falling victim to these issues.

The number and size of junk bond issues grew, despite the fact that this asset class was untested by an economic downturn, which should have made investors cautious. 

Investors were happy to gobble up zero coupon bonds (where the interest accrues to the issuer but is not paid out until the bond comes due) despite the clear risks! 

It took the downturn of the early nineties to wipe out those who were too eager to pay for assets that were risky.



Faulty Logic using EBITDA propelled the Speculation

One way investors were prodded into purchasing such securities were valuation measures based on EBITDA. 

Rather than considering cash flow or earnings, companies were valued using this accounting measure which doesn't include depreciation expenses. 

A company paying its debts from EBITDA is slowly liquidating itself (as it can't make capital expenditures) and leaving itself susceptible to a credit crunch.

Such fads will undoubtedly occur in the future, and those who are able to avoid them will do well.



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Understanding these changes in the investment world allows investors to earn superior returns

The changing scenario in the investment world

 The investment world has changed over the last several decades.

 From 1950 to 1990, the institutional share of the market rose from 8% to 45%.

 During the same period, institutions comprise 75% of market trading volume. 

The short-term mindset of the institutional investors

 The institutions are hampered by a short-term mindset.  

 Here are some reasons.

1.   Money managers tend to be rewarded not on what they return to clients, but rather as a percentage of their assets under management. 

A larger base of cash actually makes it more difficult to generate returns.

Thus there is a conflict between what's best for the manager and what's best for the investor.

2.   Institutional investors are also "locked into a short-term relative performance". 

Frequent comparative rankings among institutional investors forces a short-term mindset, as a long-term view can quickly send a manager to the unemployment line. 

As a result, these managers act as speculators rather than investors.

They try to guess what other managers will do, and try to do it first!

Only the brokers, who benefit from frequent trading, win this, as short-term market fluctuations are random. 


3.   Institutional investors are also constantly compared (and comparing themselves) to index benchmarks. 

Due to this relative comparison, they tend to prefer being close to 100% invested, even if things don't look cheap on an absolutely basis, which hurts investors when stocks are expensive.

4.  Money managers rarely invest their funds along with their clients.

In this conflict of interest situations, it is clear that the management firm wins.



Economist Paul Rosenstein:

"In the build­ing practices of ancient Rome, when scaffolding was removed from a completed Roman arch, the Roman engineer stood beneath. If the arch came crashing down, he was the first to know. Thus his concern for the quality of the arch was intensely personal, and it is not surprising that so many Roman arches have survived."



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What's good for Wall Street is not necessarily good for investors.


How Wall Street does its business?

 It has a very short-term focus. 

 For example, Wall Street makes money up-front on commissions (not from long-term performance).

 Therefore the Wall Street will always push for churn and will always push "hot" investments.




Is this business model fundamentally wrong?

Some argue that there is nothing fundamentally wrong with this business model. 

After all, many professionals make money in this manner without being responsible for the long-term results. 

It is, however, important that investors recognise this Wall Street bias, or they will be robbed blind.

This business model also encourages very short-term thinking, and a bullish bias. 

If stocks are going up, Wall Street is able to make more in the form of commissions. 

This bullish bias is seen in the percentage of stocks that are recommended by analysts versus those that are deemed "sells".

There are many examples of Wall Street's short-term bullishness that props up prices of various securities, but where those prices eventually fall dramatically. 



Take Home Message for Investors

Investors are advised to keep Wall Street's biases in mind when dealing with the Street.

Investors are to avoid depending on the Street for advice.


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