From our interview archives: Value veterans reveal their methods for finding a margin of safety.
This is part four of a new ten part series from ValueWalk on value investing. You can find the three previous parts at the links below.
- The Value Interviews Part One: Finding Value – The Process
- The Value Process
- Investors Reveal The Key To Successful Shorting
All of the quotes in this series have been taken from ValueWalk's old interview series so the investment ideas are out of date, but the descriptions of a process are still highly relevant.
If you’re looking for more up-to-date interviews and ideas, you should take a look at ValueWalk’s exclusive quarterly magazine, Hidden Value Stocks. Each issue contains two interviews with value managers as well as four stock ideas and a detailed Q&A session on each idea. Click here to find out more today.
Value Veterans Reveal How To Find The Margin Of Safety
Value Veterans: Wally Weitz Talks Investment Process, Buffett And Omaha
You mentioned your ‘on deck list.’ Could you give us a quick primer of your investment process and how ideas get on to this list?
The ideas come from all over, but once we get an idea that a company might be interesting, we’ll try to understand how the business works and what the key variables are. We need to find out everything we need to be comfortable in making a five or ten-year rough projection of cash flows. Because that’s what our valuation is based on; what an owner would be able to collect over the next five or ten years if they owned the whole company. So, if we think we know how the business does or doesn’t work, and we think earnings are going to be predictable enough — that is we can believe in our discounted cash flow model — then we’ll do the reading of the 10-Qs and 10-Ks. We’ll also read conference calls transcripts for the past three years; all the basic background checks. We’ll try to understand the competitive environment and try to understand if the company is about to be eclipsed by someone else. All the things you’d think about before buying an investment. We build a model of how the income statement works. All too often this is based on estimates, which, hopefully, we are appropriately skeptical about, but we are trying to understand how the profit margins work, how leverage works, changes in capital structure and so on. Then we do a discounted cash flow model using a 12% discount rate. And we get a number. That’s our — as I say we try and be appropriately skeptical about out inputs — but that’s our number, an approximate base case for what the business is worth. Then we’ll make a high case for, if a few things go right, how good could it be. Then a low case based on if something goes wrong — hopefully we’ve already figured out what could go wrong — we try to figure out how bad things could be, and then compare to the current price. We want to buy at a deep discount to business value. We’ll usually add a qualitative overlay to that based on how confident we are on all of our assumptions.
Value Veterans: Interview with azVALOR: Former executives of Bestinver
In your first letter to investors, you highlight the fact that you’re looking for ‘cheap companies,’ how does the fund define cheap in this case and how do you go about calculating your estimate of intrinsic value?
We first try to answer an apparently simple question: will the business be around in ten years? Then, we try to answer a little harder one: will it make more money than today, and why. If the answer is YES in both cases, we then look at the FCF yield to the firm. We are not comfortable with anything below 8-9%…Sometimes we’ve made exceptions if the ROCE is really good and the barrier to entry very solid, in which cases we can settle at 7-7.5%. Below that we do not dare to venture…
Value Veterans: Moerus Capital On The Margin Of Safety
I’d like to dig a little deeper into your investment process here. There are two main questions I’d like to ask, firstly how do you go about finding the ideas? And secondly what kind of margin of safety or discount to your estimate of intrinsic value do you look for before beginning to buy into a new position?
I’ll tackle the second part of that question first. With the regard to the margin of safety, it really depends on the opportunity in question. When I look at a business, obviously I see different types of businesses and each different type of business comes with a different level of risk. You have businesses that are relatively capital intensive, businesses that may need huge amounts of capital spending to continue operating, businesses in industries that are fragmented and businesses in industries that are cyclical. When these kind of companies appear on our radar, we expect much bigger discounts than we usually would, quite simply because there is a greater risk attached to these companies. So we estimate the value much more conservatively and look for a wider discount. Conversely, with capital-light, less-cyclical businesses in more concentrated industries, we are okay with a smaller discount.
Is there a specific discount you look for?
Not really. In the past we’ve bought at discounts of 30%, 40% and even 60% — actually, that one turned out to be by accident. I thought I was buying at a 40% discount and it turned out to be 60%.
On the other hand, if you take a company like Carnegie it was clear the business was operating in a consolidated industry, they were making money, and so there was limited risk that the business might go under. Here you could get away with buying at a discount of 20% to 30% to the very conservatively estimated Net Asset Value. But really we tend to look at it from the point of view of what sort of discount would make sense for us. We also think about our buying behavior; we like to buy more as the price falls. The first and second tranches are the least price sensitive, so when we’ve bought these, we hope prices decline further so that we can add to our position. The next tranches are more price sensitive because with these purchases the position size starts to get larger. So that’s how we think about both the discount to intrinsic value and how we implement a position.
Value Veterans: Interview with Steven Wood, the founder of GreenWood Investors
I think one of the ways that helps us “not to trip up” is our focus on the returns on capital the business can generate. A poor business will generate a return on invested capital of say 5% and for a great business it