1. hobbies and interests
2. collecting
3. stamps and coins

Approaches to Investing
Long Term
Short Term
Efficient Market
• Asset Allocation
• Cost Minimization
Fundamental Fundamental Technical
(Value)
(Value)
• Momentum
• Price/Volume Patterns
Levels
• Mkt. Price vs.
Value
Changes
• Current Price + Forecast Change
• Micro
• Macro
We Are Here
Relative Rarely Done Well
(Shliefer, Vishny, Lakonishok)
1
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
2
Real S&P 500 and Trend
3
4
5
6
7
8
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
9
Microsoft Valuation (in 2000)
Assume:
 50% dividend payout (now zero)
 40% annual growth in sales, earnings (by 2010 – 28 times
current size)
 15% discount rate (15% desired return)
Terminal Value
(depends on conditions in 2010
& beyond)
Valuation:
2000
2010
Dividends
15%Value
85%Value
Value = current price (i.e. 110)  80x earnings.
10
Value Investing the Approach
Search
(Look systematically for undervaluation)
Value
Review
Manage Risk
11
Search Criteria
• Obscure
• Undesirable
−Small Capitalization
−Spin-Offs
−Boring (Low Analyst Coverage)
−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 −Privatizations
Imbalance - RTC
12
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
13
14
15
16
Systematic Biases
1. Institutional

Herding – Minimize Deviations

Window Dressing (January Effect)

Blockbusters
2. Individual

Loss Aversion

Hindsight Bias

Lotteries
17
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
18
Summary of Search
• Low M/B, P/E,
Growth
• Disappointing
Rtns
Search
(Look systematically for
undervaluation)
• Institutional
Psycho
• Logical
Rationale
• Obscure
• Undesirable
• SupplyDemand
Imbalance
Value
Review
Manage Risk
19
Value Investing the Approach
Search
(Look systematically for undervaluation)
Value
Review
Manage Risk
20
Valuation Approaches – Ratio Analysis
Cash Flow Measure
x
Earnings
Depends on:
(Maint. Inv. = Depr + A)
EBIT
(Maint. Inv. = Depr + A; Tax =0)
(Maint. Inv. = Depr only)
(Maint. Inv. = 0)
• Economic position
• Cyclical situation
• Leverage
EBIT - A
EBIT-DA
Multiple
• Mgmt. Quality
• Cost of Capital (Risk)
• Growth
Range of Error (100%+)
21
Valuation Approaches
Net Present Value of Cash Flow

Value =
 CF (1 +1 R )
t=0
t
t
= CF0 *
1
R-g
Note: NPV Analysis encompasses ratio analysis
(NPVdiseases are ratio analysis diseases)
Note: NPV is theoretically correct
In Practice:
Revenues
Parameters:

Market Size

Market Share

Market Growth

Price/Cost


Forces:

Consumer
Behavior

Competitor
Behavior

Cost Pressures

Technology

Tech

Management
Performance
Margins
Required
Investments
Tech
Investment
Management
Performance
Cash Flows
Cost of Capital
X
NPV </> Market Value
22
Shortcomings of NPV Approach in
Practice
(1) Method of Combining Information
20
NPV = CFo +CF1
1
1+R
Good
Information
(Precise)
+ … +CF20
1
+ ...
1+R
Bad Information
(Imprecise)
= Bad/Imprecise Information
(2) Sensitivity Analysis is Based on Difficultto-Forecast Parameters which co-vary in
fairly complicated ways
Profit
Margin
Cost of
Capital
Required
Investment
Growth
23
Valuation Assumptions
Traditional:
Strategic:
• Profit rate 6%
• Industry is economically
viable
• Cost of capital 10%
• Investment/sales 60%
• Entry is “Free” (no
incumbent competitive
advantage)
• Profit rate +3% (i.e. 9%)
• Growth rate 7% of
sales, profits
• Firm enjoys sustainable
competitive advantage
• Competitive advantage is
stable, firm grows with
industry
24
Value Investing
Basic Approach to Valuation
“Know what you know”; Circle of competence
1. Organize valuation components by reliability
Most Reliable
Least Reliable
2. Organize valuation components by underlying
strategic assumption
No Competitive
Advantage
Growing Competitive
Advantage
25
Basic Elements of Value
Strategic Dimension
Growth in Franchise Only
Franchise Value
Current Competitive Advantage
Free Entry
No Competitive
Advantage
Asset Value
Reliability
Dimension
• Tangible
• Balance Sheet
Based
• No
Extrapolation
Earnings Power
Value
• Current
Earnings
• Extrapolation
• No Forecast
Total Value
• Includes
Growth
• Extrapolation
• Forecast
26
Industry Entry - Exit
Industry
Market Value
Net Asset Value
Entry
Chemicals
(Allied)
$2B
$1.5B
$1.0B
$1B
$1B
$1B
Yes (P  MV )
Yes
Stop
Automobiles
(Ford)
$40B
$30B
$25B
$25B
$25B
$25B
Yes (Sales  MV)
Yes
Stop
Internet
$10B
$0.010B
?
Remember, Exit is Slower than Entry.
27
Asset Value
Basic GrahamDodd Value
Assets
Reproduction Value
Cash
Book
Book
Accounts Receivable
Book
Book + Allowance
Inventories
Book
Book + LIFO
PPE
0
Orig Cost  Adj
Product Portfolio
0
Years R & D
Customer Relationships
0
Year SGA
Organization
0
Licenses, Franchises
0
Private Mkt. Value
Subsidiaries
0
Private Mkt. Value
Liabilities
A/P, AT, AL
Book
Book
Debt
Book
Fair Market
Def Tax, Reserves
Book
DCF
Bottom Line
Net Net Wk Cap
Net Repro Value
28
Asset Value Approaches
Approach
Graham
Book
Reproduction
Opportunities
None
Limited
More Extended
Value in Practice
Yes
Yes
Yes
None
Extensive
Industry Knowledge None
Stability/Reliability
High
Low
Intermediate
Goodwill
0
Historical
Reproduction
Debt
Book
Book
Est Market
(Low Debt)
(0 Enterprise)
(0 Enterprise)
Remember, Low M/B is very hard to beat.
29
Asset Value Issues
• Management
• Good adds value
• Bad subtracts value
• Private Market
Values
• Potentially highly unstable
(EBITDA multiples of
Internet subs)
• Reproduction vs.
Book
• Better where accountants
misestimate
Tech trends
 Real estate
 Intangibles

• M/B indicator close to M/Repro
value
• Improvement requires
discipline
• Non Viable
Industries
• Value = Zero (except NWC)
30
Asset Value Risk Management
• Private biases
• Personal computer
industry
• Psychological
experiments
• Evidence of investment
behavior in life
• Catalysts
• Takeover
• Reorganization
• Management change
• If don’t know, don’t play
• Importance of
industry knowledge (Circle of Competence)
• Hedging
• Limited
Ultimately, “Margin of Safety” is risk
management tool
(Otherwise diversify)
31
Earning Power Value

Basic Concept – Enterprise value based on this
years “Earnings”

Measurement
1
– Earnings Power Value = “Earnings” * Cost of capital

Second most reliable information earnings today

Calculation
– “Earnings” – Accounting Income + Adjustments
– Cost of Capital = WACC (Enterprise Value)
– Equity Value = Earnings Power Value – Debt.

Assumption:
– Current profitability is sustainable
32
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).
33
Earning Power Value Calculation
WACC = Cost of Capital = (Fraction of Debt) (RD) (1-Tax)
+ (Fraction of Equity) (Cost of
Equity)
Fraction of Debt = 1- Fraction of Equity  Actual or
Potential
Zero Growth Capex =
Actual Capex - Growth Capex
Growth Capex = (PPE/Sales) *  Sales
Balance Sheet
34
Earning Power and Entry - Exit
Value Lost to Poor
Management
and/or Industry
Decline
Case A:
Asset Value
EP Value
Free Entry
Industry
Balance
Case B:
Asset Value
EP Value
Consequence of
Comp. Advantage
and/or Superior
Management
Case C:
Asset Value
EP Value
“Sustainability” depends on Continuing Barriersto-Entry
35
Franchise Value Calculation
(A1) Cost of Capital
= 10%
(A2) Asset Value “AV”
= 1200M
(A3) Earnings Power Value = 2400M = 240M X (1 / 10%)
“Earnings”
• Competitive “Free Entry Earnings” = 120M
= Cost of Cap. X Asset V
= 10% x 1200
• Franchise Earnings = “Earnings” – “Free Entry Earnings”
= 240
-
120
= 120
(A4) Sales = 2000M (Tax Rate = 40%) Power Value = 2400M
= 240M X (1 / 10%)
• Franchise Margin = 120M ÷2000M = 6% after tax
• Franchise Margin (pre-tax) = 10%
= (10% - 40% X 10% = 6%)
Tax
EP Value Implies Sustainable 10% Cost and/or Pricing
Advantage
36
Earnings Power Value Issues

Nature and sustainability of barriers-toentry (competitive advantage)

Sustainability of management quality

Quality of reinvestment opportunities

Value of cash
–Subtract interest earned from
–EBIT add
–Cash to EP value

Inflation adjustment
37
“Real” Earning Power Value
“Real” Earnings = “Earnings” – Inflation driven Investment
“Real” Cost of Capital = WACC – Inflation Rate
Inflation Driven Adjustment = Net Assets (Not including
‘goodwill’ items) * Rate of Inflation
Example:
(A1) EP Value = 2400M = 240M * 10%
(A2) Net Assets (not including goodwill) =
Cash + AR + Inv. + PPE – A/P – AL – AT = 800M
(A3) Inflation rate = 2%
• Inflation Driven Adjustment = 2% * 800M = 16M
• “Real” Earnings = 240M – 16M = 224M
• “Real” Earnings Power =
224
= 224 = 2800M
10% - 2% 8%
38
Summary of Basic Valuation
Compute:
Asset Value (Most reliable)
EP Value (Second most reliable)
Case A: Asset Value EP Value Value = EP Value
(500M) (300M)
+ Catalyst Value
Case B: Asset Value = EP Value Value = 500M
(500M) (500M)
Case C: Asset Value EP Value Value = Asset Value
(500M) (1000M)
+ Sustainable
Fraction
of Franchise Value
(1000M-500M)
39
Summary of Valuation
Strategic vs. Traditional Approach
Traditional
Revenue
Oper Income
(EBIT)
Cash Flow
NVP
Market Size Estimate
Market Share
Operation Margin
Investment
Cost of Capital
National Income,
Growth, Consumer
Trends
Competitive
Responses;
Entry/Exit
Technology,
Costs;
Prices; Input
Costs
Technology,
Growth
Financial
Market
Conditions;
Risks
Value
Strategic: Is this the South Bronx of the Investment World?
40
Basic Strategy Framework
Porter Five Forces – Probability Determinants
Substitutes
Suppliers
Customer
Industry
Competition
Entrants
Four Forces too many
41
Strategic Investment Forces
•
Entry-Expansion – Barriers-to-Entry
“Incumbent Competitive Advantage”
Does this company enjoy competitive advantage that is
significant?
 Yes – Being industry creates value
 No – Efficient Operation may create value
 Others enjoy advantage – stay out. (Being in industry
destroys value)
What about entrant advantages?
 No good – after entry you become incumbent.
•
Existing Competitor Dynamics  Degree of
Competition (Phillip Morris)
•
Share the Wealth (Workers, Customers)  Value
Chain Dynamics
42
Consequences of Free Entry
Commodity Markets (Steel)
$/Q
“Economic Profit”
AC
ROE (20%) > Cost
of Capital
Entry/Expansion
Price
Supply Up, Price
Down
Q
Firm Position
(Efficient Producers)
$/Q
ROE = 12%
AC
No Entry
No Profit
Price
Q
Firm Position
43
Consequences of Free Entry
Differentiated Markets (Luxury Cars)
$/Q
“Economic Profit”
AC
ROE (20%) > Cost
of Capital
Entry/Expansion
Demand for Firm
Demand Curve shifts left (Fewer
Q
sales at each
Firm Position
Price)
ROE = 12%
$/Q
No Entry
No Profit
AC
Demand
Curve
Q
Firm Position
44
Barriers to Entry
Incumbent Cost Advantage
Entrant
No “Economic”
Profit
Incumbent
“Economic” Profit
ROE = 20%
Sources
Proprietary Tech
(Patent, Process)
ROE = 12%
Learning Curve
No Entry
Special Resources
• Not Access to Capital
• Not Just Smarter
45
Barriers to Entry
Incumbent Demand Advantage
Entrant
Incumbent
No “Economic” Profit Higher Profit, Sales
ROE = 12%
No Entry
ROE = 20%
Sources
Habit (Coca-Cola)
• High Frequency
Purchase
Search Cost (MD’s)
• High Complex
Quality
Switching Cost
(Banks, Computer
Systems)
• Broad Embedded
Applications
46
Barriers to Entry
Economies of Scale
• Require Significant Fixed Cost
(Internet)
• Require “Temporary” Demand
Advantage
• Not the Same as Large Size
(Auto + Health Care Co)
47
Barriers to Entry
Economies of Scale
• Advantages are Dynamic and Must be Defended
• Fixed Costs By:
• Geographic Region (Cohrs, Nebraska Furniture
Mart, Wal-Mart)
• Product Line (Eye Surgery, HMO’s)
• National (Oreos, Coke, Nike, Autos)
• Global (Boeing, Intel, Microsoft)
48
Barriers to Entry - Sustainability
Static Demand Advantages
•Tied Customers
Exploitation
•Pricing, focus on “Own” Customers
•No advantage with Virgin
customers
•Shrinkage over time as base
changes
Static Cost Advantages
•Cost efficiency in “Own” technology
•No advantage with virgin
technology
•Shrinkage with technology change
Economies-of-Scale + Dynamic Demand Advantage
• Principal sustainable advantage
• Constant vigilance
49
Other Barriers-to-Entry
• Government, Regulatory, Public
(Lead based Gas Additives; Cigarettes)
• Informational (Who Knows What)
(Banks, Financial Services, HMO’s)
50
Performing Strategic Analysis
(1)
Industry Map
(2)
Do barriers
Exist?
(3)
What
Competitive
Advantages?
(4)
Future Strategy,
Profitability
Identify Industry
Industry History
Demand? Cost?
Economies-ofScale?
51
Performing Strategic Analysis
Apple Computer - Industry Map
Industry: Chips
Software
Hardware
Microsoft,
Intel, AMD, Dell, HP,
Gateway,
Apple,
Motorola,
IBM, Compaq, Oracle,
Apple
Apple
Netscape
Networks
AOL
Components
Power Supply
Co.’s, etc.
Step 1:
• Identify Segments
Step 2:
• Identify firms in each segments
Step 3:
• If firms are the same, treat
segments as Single Industry
•If firms are different, treat segments
as Separate industry
•If in doubt, treat segments as
separate industries
For Apple Segment Are:
• Chips
• Hardware
• Software
52
Performing Strategic Analysis
Do Barriers/Competitive Advantage Exist
53
Performing Strategic Analysis
Nature of Barriers-to-Entry Competitive Advantage
54
Other Strategic Considerations

Cooperation within Barriers
–Coke – Pepsi
–Cigarette Makers

Division of Spoils in Value Chain
–Strategic alliances
–You can not take home, if you don’t bring
(NuKote)
–Employee Power (unions, Prof. Services
firms)
55
Summary of Strategic Investment





Without Competitive Advantage –
no Value in Franchise
Competitive Advantage must be
identifiable and sustainable
In particular, Are existing
Competitive Advantages
Sustainable or are they likely to
erode?
If in doubt, do not pay for
franchise
Ideally look for ‘hidden’ franchise
–Unused pricing power (Coke, Cereals)
–Poorly performing divisions
56
Total Value Including Growth




Least reliable - Forecast change
not just stability (Earnings Power)
Highly sensitive to assumptions
Data indicates that investors
systematically overpay for growth
Strict value investors want growth
for “Free” (Market Value <
Earnings Power Value)
57
Value of Growth - Basic Forces At Work
• Growing Stream of Cash Flows is more
Valuable than a Constant Stream
(relative to current Cash Flow)
• Growth Requires Investment which
reduces current (distributable) Cash
Flow
58
Value of Growth - Basic Algebra
59
Valuing Growth
Case 1:
 ROC Return on Capital  Cost of Capital R
 Then ROC – G
R–G
=
= 1 (for all growth rates)
R–G
R–G
e.g. (ROC = R =
10%)
ROC = R when there
are no Barriers-toEntry (i.e. no
competitive
advantages – level
playing field) then
Growth has no Value.
G = 0%
ROC – G
R-G
=
10 - 0
=1
10 - 0
G = 2% ROC – G =
R-G
10 - 2 = 1
10 - 2
G = 8% ROC – G =
R-G
10 - 8
=1
10 - 8
60
Valuing Growth
Case 2:
 Competitive disadvantage with growth
ROC less than cost of capital
 then ROC – G < R - GROC – G < 1

R–G
and ROC – G gets smaller with higher growth rates.
R–G
e.g.
(ROC = 8%, R=10%)
Higher Growth at a
Competitive
Disadvantage Destroys
Value
G = 0% ROC – G= 8 - 0 = .8
R-G
10 - 0
G = 2% ROC – G = 8 - 2 = .75
R-G
10 - 2
G = 8% ROC – G = 8 - 8 = 0
R-G
10 - 8
61
Valuing Growth
Case 3:
 ROC is greater than R – Firm enjoys a competitive
advantage (franchise)
Shares are stable  G = Industry Growth Rate


then ROC – G is greater than R – G
and ROC – G is greater than 1 and increasing in G.
R–G
e.g. (ROC = 15%, R =
10%)
G = 0% ROC – G = 15 - 0 = 1.5
R-G
10 - 0
G = 2% ROC – G = 15 - 2 = 1.625
R-G
10 - 2
Only within Franchise
Growth creates Value
G = 8% ROC – G = 15 - 8 = 3.5
R-G
10 - 8
62
Valuing Growth Basics



Growth at a competitive
disadvantage destroys value
(AT&T in info processing)
Growth on a level playing field
neither creates nor destroys
value
(Wal-Mart in NE)
Only franchise growth (at
industry rate) creates value
63
Valuing Growth - How much Does it
Add?
64
Valuing Growth
High (Unstable) Growth
65
Valuing Growth
Breakeven Growth Rate
66
Valuing Growth
Keep-In-Mind




Very hard to do
Very hard to determine margin of
safety
Evidence is that Investors
systematically overpay
Best growth is hidden (zero cost
growth)

Unused pricing power

Temporary problem

Underperforming divisions
67
Summary of Valuation
Search
(Look systematically for undervaluation)
Value
Review
Manage Risk
68
Managing Risk – Overall Valuation

Review biases

Look for asset protection

Adequate margin of safety (1/3)


Identify catalysts (create
catalysts?)
Appropriate search rationale
69
Summary of Valuation
Asset
Value
EP
Value
Most
certain
but mgt.?
Medium
certain
Sustainable?
Growt
h
Value
MV < AV,
EPV
AV < MV <
EPV
AV, EPV <
MV
BUY
Assess Comp.
Adv.
Lots of
Luck
Uncert
ain
Sustainable?
Yes
No
BUY
Lots of
Luck
70
Summary of Valuation
Strategic Dimension
Growth in Franchise Only
Franchise Value
Current Competitive
Advantage
Free Entry
No Competitive
Advantage
Asset Value
Reliability Dimension • Tangible
• Balance Sheet
Based
• No
Extrapolation
Earnings Power
Value
• Current
Earnings
• Extrapolation
• No Forecast
Total Value
• Includes
Growth
• Extrapolation
• Forecast
71