Value Investing:

Applying Graham and Buffett

Raimondas Lencevicius
Disclaimers
I am not a registered investment advisor and I do not offer any
investment advise
No parts of this talk are suggestions to invest, not invest, buy or
sell any kind of securities or other financial instruments
For short term traders and technical analysis adherents:
This talk is about fundamentals and long term investing (usually 6 months
to forever)
I will not cover any topics of how to integrate TA or trading with value
investing
This talk covers the way I practice Value Investing, there are
other ways to value invest that are not covered
Not exact Buffett and Graham but my adaptation
Value investing - buying something cheaper than for
what it is worth
Not very useful definition this talk digs into it
Different value investing approaches
"Buffettology buying cheap earnings in great companies
"Net-nets", Graham buying assets cheaply
Buffettology
Buying stock is buying a business
Is it a good business?
Is it cheap?
Is it good business?
High ROE
High margins
Moat
ROE Return on Equity
Equity = All assets all liabilities
In simple cases: capital put into business
ROE = Earnings/Equity
How much business returns on what you have put into it
Buy windmill for $10K, returns $1K in electricity production per year =
10% ROE
Most businesses more complicated
Good ROE: >15% for last 5-10 years
Based on cost of capital
Businesses with lower ROE may not be returning cost of capital to
owners
Examples:
NKE 19.80 21.50 22.10 21.20 24.10
GRMN 28.90 25.00 23.70 23.80 22.00 26.90 33.00 36.40
Assumes low debt
Usually < 1 D/E or < 0.5 D/E
Zero debt is best - overcapitalized
Can use ROIC if there is debt
ROIC = Earnings / (Equity + Debt Cash) = Earnings / (Assets non-debt
liabilities - Cash)
Cash flows vs. earnings
Net margins >10%
High margins usually indicate some economic moat
Pharmaceuticals, branded goods
>15% operating margin, >10% net margin
Possible to buy low margin businesses which are category killers
Nike (7-10%), Walmart (3-4%), Cemex(4-8%), BNI (8-12%)
Company should have good moat
Somewhat indicated by high long term ROE
Somewhat indicated by high margins
Subjective analysis
Have things changed?
Diworsefication buying unrelated low margin businesses
Squeezing out returns without regard to risk FNM, monoline insurers
Loss of patent protection pharmas
New threats newspapers
Value chain destruction ratings agencies (Moodys)
Fads Krispy Kreme, Crocs
New moat creation railroads
Areas of expertise and areas outside "circle of knowledge
Is business cheap?
Value business for its earnings
How much money would I make if this was my private company?
How much money company will make in 10 years?
Assuming average ROE what will be the earnings in 10 years?
P/E in 10 years?
Rate of return?
Example: NKE
Average ROE 20%
Earnings in 10 years = ROE*Equity*(1+ROE)
9
= $8B
Market cap = $8B x P/E (15) = $121B
Rate of return = ~13% after tax (calculations omitted)
Approximately right calculation
Do not decide 13.6 vs 13.2% situations, decide 5% vs 15% situations
Discounted cash flow if needed
Caveats
Very few companies are really Buffettology companies
Few examples in these slides may not be true Buffettology companies J
Need careful scrutiny
Usually cheap when something is going wrong is this temporary?
New Coke, Amex disasters temporary
FNM, FRE gone
Moodys?
Think and discuss meticulously
Usually large caps followed by a lot of other people!
Are you right while others are wrong?
Net nets Graham Asset based investing
Buying a dollar for half dollar
Still looking at whole business but very different from
Buffettology!
Buy business, sell all assets = PROFIT!
Buy antique watch from pawnshop for $1, sell to collector for $1000
Usually small cap
Usually smelly dinky cigar butt companies
Cant boast in a bar! J
Is this dollar selling for half-dollar?
Best: below net cash value = cash + equivalents all liabilities
Very good: below net current assets =
current assets all liabilities
Good?: below book or tangible assets =
tangible assets all liabilities
Analyzing assets
Cash is king
Cash equivalents may not be so! Need to check
Current assets
Inventory how sellable it is?
Accounts receivable will company receive them?
Other assets
Plant, equipment does it have any value at all?
Land, real estate may be undervalued or overvalued
Usually no need to analyze liabilities they are all real
Analyzing assets examples
GSIT 1/2008:
Current assets: 78M, liabilities 10M = 68M Net current asset value, 74M book
value
Sold for 2.3-2.5 x 29M shares = 67-72M cap
ACTS now:
Current assets: 284M, liabilities 20M = 264M Net current asset value, 286M
book value
Sells for about 2.8, 240M market cap
Beyond assets of net-net
Earnings of net-net
Profitability is preferable even if it is marginal
Low debt
Like in Buffettology
High debt companies can go BK even with positive net assets
Business outlook
Perennial net nets: distributors
Examples
GSIT - profitable in Sep-Dec 2007, Jan-March 2008, no debt
ACTS profitable, no debt
Safety in value investing
Buffettology
Safety of great business
Moat ensures that company will continue to earn great return on capital
Future earnings returned to shareholders can ensure good return even if
there was no stock market
Net-nets
Safety of asset value
Company can go private, be acquired, etc.
When to sell value investment?
Buffettology
Hold forever, pass to your kids and so on
KO
Hold till overvalued expected return of future cash is too low
BNI, KO in 2000, MA
Net-nets
Shorter term hold usually up to 2-3 years
If does not work out in that time, probably perennial net-net
Sell at 1.5-2x book
Takeovers, takeunders, etc.
Possibly short term capital gains, better in tax protected accounts
What to do when prices drop?
For most value investments, prices drop after you buy them
Buffettology
If fundamental business has not changed add
If fundamental business has materially deteriorated sell
In reality decision is difficult, since business usually changes negatively
AXP, MCO
Net-nets
If balance sheet has not changed and business is not going to lose a lot of
cash add
If balance sheet has deteriorated and company is no longer a net-net OR
business is going to lose a lot of cash sell
May be possible to use TA, stops, etc.
Value investing resources
Value investors are cheap J
Dont buy subscriptions, dont buy charting tools, dont buy Value Line (well, maybe
J), dont buy mansion, BMW, yacht, etc. J
Company information
10 year data: http://www.gurufocus.com/ - some errors!
10 year data, graphs only for Quicken users:
http://investing.quicken.com/research/evaluator.asp?symbol=nke
Recent financial statements: Yahoo Finance, Google Finance, SEC
Ideas from other value investors
Buffett, Berkshire Hathaway news, SEC fillings, etc
Whitman, TAVFX letters to shareholders
Ariel Fund letters to shareholders
Blogs just know which ones are value investors J
Value Investing Congress
Questions and Future Plans
Interested in:
More in depth income sheet or balance sheet analysis talk?
Value investing meetings analyze concrete companies, stocks,
etc.
Any other suggestions
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