Approaches To And Essentials Of Value Investing by CSInvesting
Essentials of Value Investing
Long-Term Fundamental (Look at Underlying Businesses)
Specific Premises:
- Mr. Market is a Strange Guy
- Prices diverge regularly from fundamental values
- You Can Buy Underpriced Stocks
- Fundamental values are often measurable
- Fundamental Value Determines Future Price
- Buying underpriced stocks plus patience implies superior returns
Value Investing in Practice
Long-Term Fundamental (Look at Underlying Businesses)
1) Look Intelligently for Value Opportunities (low P/E, M/B)
- Mr. Market is not Crazy about Everything
- This is the first step not to be confused with Value Investing
2) Know What You Know
- Not All Value is Measurable
- Not All Value is Measurable By You (Circle of Competence)
3) You Don’t Have to Swing
- Value Implies Concentration not Diversification (look for Margin of Safety)
- At Worst, Buy the Market
Value Investing the Approach
Search Criteria
- Obscure
– Small Capitalization
– Spin-Offs
– Boring (Low Analyst Coverage)
- Undesirable
– Financial Distress, Bankruptcy
– Low Growth, Low P/E, Low M/B
– Industry Problems (Bad Loans, Regulatory Threat, Overcapacity)
– Company Problem (Lawsuit, Poor Subsidiary Performance, Poor Year)
– Disappointing (Long-Term Under performance)
- Supply, Demand Imbalance – RTC
– Privatizations
Stocks as Underpriced Assets
- Stocks historically outperform bonds, etc.
- Stocks are not that much more risky
But today…
Stocks: E/P = 4% + 1½ % = 5½ % vs. 11%
Inflation Historical
Bonds: 5% vs. 3½ % at comparable inflation rates
Notes: 4 ½ % vs. 2%
Stock under valuation not so clear
Systematic Biases
1. Institutional
- Herding – Minimize Deviations
- Window Dressing (January Effect)
- Blockbusters
2. Individual
- Loss Aversion
- Hindsight Bias
- Lotteries
Loss Aversion – Example
- In addition to whatever you own, you have been given $1000. Choose Between:
– $1000 with Prob .5 $ 0 with Prob .5
– $500 with Certainty
- In addition to whatever you own, you have been given $2000. Choose between:
– -$1000 with Prob .5 $ 0 with Prob .5
– -$500 with Certainty
Earning Power Value Adjustments
“Earnings” = EBIT (From Financial Statement)
+ One Time Charge Adjustment (if charges before tax average 20% of EBIT – 5 years – then reduce EBIT by 20%)
+ Cyclical Adjustment (calculate peak-to-trough EBIT variation – say 20% of average. If a peak subtract 29% of EBIT)
+ Tax Adjustment (apply average tax rate to EBIT – debt tax shield in WACC)
+ Depreciation Adjustment (Depr + Amort – Zero Growth Capex)
+ Subsidiary Earnings Adjustments
+ Other Adjustments (Temporary Problem, Unused Pricing Power).
See full slides below.
