My “Lecture” on Value Investing

My “Lecture” on Value Investing
CC Investment Masters Class - with permission

My "Lecture" on Value InvestingI was supposed to give a 1 hour guest lecture at an MBA program for students who had never been exposed to value investing.

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The lecture was pushed off and when I (hopefully) do give the lecture it will be on a different topic.  I was supposed to focus on certain famous investors, previous interviews I conducted, and weave it all in. Part of this outline is informal and part is formal (this also gives me an excuse for all my grammar and spelling mistakes). I fixed it up a bit and figured I would post it on Value Walk instead of just deleting it.


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“The concept of value investing is like an inoculation- it either takes or it doesn’t– and when you explain to somebody what it is and how it works and why it works and show them the returns, either they get it or they don’t.”- Warren Buffett


My experience as a speculator started about twelve years ago during the height of the tech bubble. I made my parents a fortune buying AOL and watching the stock quadruple. However, in hindsight it was all luck. For many years after that I thought I was the king of the world. However, my stock picks were based on hot tips and even stock alerts I got by email. Even while the market was rallying in 2003-04, my stocks were down. I no longer thought I could beat the system. One day I saw an advertisement for a free copy of a book Warren Buffett described as “the best book on investing ever written.” I had heard of Buffett and decided to search the Internet for the book. It turned out to be the The Intelligent Investor. I went to the library, took out the book and almost immediately realized that all the mistakes Graham described were ones I made. I became a value investor that day. I devoted much time to learning about value investing, behavioral finance, and to reading company filings.


What I am doing now. Interviews I conducted.

EMT debunked by value stocks which outperform with lower beta aka “risk” according to Paul Sonkin, Good article on the topic-What Do Financial Economists Have to Say About “Value”?

Back to Benjamin Graham.

Father of not only investing, but value investing.

Value investing can be defined as buying a $1 for 0.50

Lack of focus on macro, or politics even while investing in the depression he never discussed economic policy once in the Intelligent Investor.

Net-nets, focus on “cigar butts, you are buying liquid capital for cheap.

Earnings growth over the most recent ten years of 7% compounded, I always wondered why ten years? It seems too extreme and makes a company much more expensive if earnings are growing. So I saw some numbers from Enron’s accounting and they were only able to keep it up for 5 years after that the scandal started to unfold. Besides offering a higher margin of safety, it also protects you from vast majority of fraud cases. Most frauds can manipulate earnings for a few years at most, but not for ten years.

Studies have shown that a basket of net nets outperform significantly but you can be killed if you buy one.

John Dorfman who I interviewed wrote about some net nets in early 2009 and they went up like 500% when the market recovered.

Hard to find net nets nowadays many investors will use NCAV instead.

Intelligent investor reads like it was written yesterday at any time: 2003, 2009 and today!

Benjamin Graham Hated tech and Financials.

Warren Buffett wanted to work for him for free, but Graham told him he was overvalued.

Finally decided to take Buffett

Buffett after meeting Charlie Munger and reading Philip Fisher slowly evolved.

Fisher talked about scuttlebutt.

IMHO its very hard to describe Buffett’s investing style.

Buffett calls himself 85% Graham and 15% Fisher I would argue it’s the opposite. I would also say almost no one understands how Buffett values a company. Since Buffett only invests $100m minimum he is limited to a few dozen companies yet very few people can predict (have predicted) what he will buy next.

One thing he likes is moats. Coke his biggest holding has the ultimate moat, Buffett said something like if I gave you $50billion you could not make a competitor to bring down coke.

On topics of moats there are various definitions.  Pat Dorsey who I interviewed writes about four types of moats. He called network effects the strongest moat i.e. about 85% of U.S. credit card traffic goes through Visa, MasterCard, Amex and Discover. It would be very hard for some credit card to come in and for merchants and consumers to sign up.

However, one thing that is important to know is that size is not a moat. Dorsey mentioned GM as an example.

Buffett likes good management but said the company economics are more important. “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact, “

Dorsey mentioned JetBlue as an example, David Neeleman phenomenal manager starts Jetblue but it is a commodity business, meaning that there is little airline loyalty if you want to fly to NY now you go on to and  find the cheapest flight you are not going to pay $500 instead of $300 just to fly Delta.

Barriers to entry Buffett also likes. One example is Moody’s I think every bond needs to get a rating from Fitch, S&P, or Moody’s the Government gives them a natural moat. For a new agency to start up they would not only need tons of cash but Gov. Approval.

Just to mention Moody’s, David Einhorn is short the stock. He is not on the syllabus but he is freaking good! His indepth analysis of companies is astonishing. When he was examining a company called Allied capital; he noticed that one year the auditors took out a line that was there in the previous year. This was a company he was researching for 6 years, reading thousands of documents! Bill Ackman also with his short of MBIA, he read through 140k pages of documents!

It is not so easy to beat the market but there is a magic formula, we will get back to it soon.

Roger Lowenstein who I interviewed knows Seth Klamran (also not part of the syllabus) and said that the amazing thing about Klarman is that most financial advisors, the media etc. will say okay go allocate money to gold, and emerging markets etc.  Seth doesn’t wake up in the morning and say, “I need more exposure to foreign markets, domestic markets, stocks or bonds”; he looks for future streams of cash that are underpriced.

He is prepared to hold cash he is very disciplined. He buys the weirdest companies also that no one ever heard of.

Back to quantitve investing, Guy Spier who I interviewed with is friends with Mohnish Pabrai.  I also spoke to Mohnish but it was off the record, but he basically made a checklist for investments, guy Spier has it, but could not reveal it without Pabrai’s permission.

Both of them try to learn from their mistakes, Warren Buffett’s mistakes etc. The check list is 87 things.

No company will have all 87 of them but there are some that raise red flags.

It also causes someone to remain disciplined, and not just go for some hot stock.

Guy Spier was invested in a company where the CEO was getting divorced, and it seemed his decisions were driven by his personal life. That is just one example of using a check list.

So I mentioned net nets, and why doesn’t everyone just buy them it is a magic formula for investing? Well first they are hard to find. So Joel Greenblatt came up with another formula called the magic formula; take the companies with the highest earnings yield (cheap) and high returns on capital (qualititve features), Greenblatt makes a few adjustments for how to calculate earnings and ROC but he says buy a basket of 20-30 stocks and you will outperform significantly.

Why don’t people do it? Greenblatt says people get frustrated since it does not perform all the time, it usually works out over 3 year periods but most people want to make quick money.

Also I personally think that people find it exciting to try to beat the market using their own tools instead of magic formulas.

Other research has confirmed Greenblatt and net net types of situations. David Dreman who is probably one of the most under-rated investors and Tweedy Browne have shown that if you take a basket of the stocks with the lowest p/e, p/b etc. you will outperform the market significantly in every country and every time period.

Francis Chou who I spoke to basically said you can buy a basket of cheap stocks doing very little research.

I think also besides people making quick money it is mentally tasking. Using any approach requires significant amounts of discipline and patience. Everyone says I was going to buy stock X in early 2009 or should have. I ask them if the stock dropped to that price now would you? Most answer no, the few who answer yes are lying and 1% are honest and missed out. Today is a perfect example where a lot of those opportunities especially in financials and materials have risen again.

It is much easier said than done. When the market was crashing in late 08 and early 09 I kept buying and buying. I try to keep cash but there were so many bargains that I sold stocks like Coke at 38 to buy Movado at 5 (then a net-net, which was burning very little cash). It is hard to see your savings going down day after day.

That is what ties all these investors together. They have extreme discipline that is the key to success in investing. I would say less than 10% of people can master that, and even then you have to convince investors many times if you are running a fund, and also most of these investors even the quantities ones use some qualitative methods to produce even higher returns.  But in conclusion what all these investors have in common is extreme patience and discipline.

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