Value Investing

What is Value Investing or for the fun of it Value Investhink (a new terminology coined here)?

Value Investhink is the combination of Value Investing, the key concept behind long-term, fundamental investing and Critical Thinking, an important skillset that is not taught well in schools but is critical in the real world.

This Page serves to help the un-initiated learn about Value Investing from the very beginning. There is also another Page on Critical Thinking.

The goal of this blog is to help its readers adopt a rational framework about investing. One of the best investment framework is the VALUE INVESTING framework pioneered by Benjamin Graham and glorified by Warren Buffett, the world’s greatest investor. Investments here can refer to stocks, bonds, markets, properties or even other alternative assets but we shall focus on stocks, or equity investing.

Investing is perhaps one of the most important topics in life that is misunderstood by the most people. This is again a reflection of our modern society that constantly tries to replace rationality, long term thinking and hard truths with sensations, material gains and get-rich-quick mentality.

It is a sad fact that most people today equate investing with gambling when the segregation can be crystal clear. To quote Benjamin Graham, father of value investing, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return and operations not meeting these requirements are speculative”.

Adding in a bit of context, analysis here refers to work being done to determine what is the INTRINSIC VALUE of the investment in question. The intrinsic value here is the true worth of a stock, or the correct valuation of a property. This is something that does not change every day, and is determined by the future cashflows that the investment generates.

In contrast, PRICES of stocks and shares and that of real estate properties change daily (or almost daily). Most people like to follow prices. The whole practice of following prices developed into a discipline called technical analysis where chartists plot lines and triangles to determine where prices will head in the future.

Price following is exciting. Talking heads are always predicting prices. An expert on TV cannot escape that question: It is going up or down? He or she must say something about where prices will go. It doesn’t matter what the logic behind is. But the truth is, in the short run, prices are unpredictable.

It is more worthwhile to follow, or rather, determine value, not price. Because prices must ultimately revert to values. It may deviate for a long time, such as the Singapore property market and it may deviate by a lot, such as during the dotcom bubble but ultimately, just as the sun rises from the east, price must follow value in the end.

The goal of investing is to buy at a PRICE that is significantly below the investment’s VALUE.

VALUE INVESTING

In very basic terms, value investing simply means adopting an investment philosophy to buy something that's worth a dollar with a lot less, like 70 cents or less. This means buy when the price is much lower than its value.

An official definition:

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Value investing is a broad definition of a style of investment that follow two basic principles:
1) Buying investments at a price that is less than its intrinsic value
2) But with a MARGIN OF SAFETY
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Over the years, the paradigm of value investing has expanded to encompass many things:

1. Fundamental analysis (FA) needs to be rigorously employed in order to determine a stock's intrinsic value. This plots value investing into the infamous FA vs TA argument. TA stands for technical analysis which we defined above.

2. Buying a stock is like owning a business. Hence long investment horizon becomes norm as business owners don't buy and sell their companies within the week, or days, or for that matter, minutes. And also undervalued stocks usually take some time to revert to its intrinsic value.

3. Stocks that have certain characteristics become known as value stocks:

i) predictable business operations and stable earnings (easier to calculate its intrinsic value),

ii) Value stocks usually have low valuations such as low Price Earnings Ratio (PER), low Price to Book Value (PBR), high dividend, high cashflows.

4. Based on the points raised in 3, value stocks typically come from mundane industries like food and staples, utilities and other old economy industries ie no high-tech, alternative energy or bio-venture stuff.

5. It is generally accepted that Benjamin Graham is the father of value investing. Other well-known value investing practitioners include: Howard Marks, David Einhorn, John Templeton, Charlie Munger and Warren Buffett.

MARGIN OF SAFETY

Margin of safety refers to buying a stock way below its intrinsic value. The general rule of thumb is at least 30% lower if not more. This simple but rational rule is paramount. It is said that if one has to surmise the whole concept of value investing in three words, it is margin of safety. It is that important.

The most common analogy here by Warren Buffett is this: "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing."

As we shall see, intrinsic value and margin of safety goes hand-in-hand because we cannot accurately determine value. Precisely because value is elusive, we need a margin of safety to buffer us from our calculation error. For most Singaporeans being brought up studying core mathematics and science, where we need to give answers to at least 2 decimal places, it is a very hard truth that most cannot accept: we cannot accurately determine value.

It must be highlighted that investing is more of an ART than a science. Just as we like the Impressionism Masters capturing in oil paintings, dreamily, the state of affairs in the 18th century, we can only have a rough sense of value. We can never calculate the intrinsic value of a stock to 2 decimal places.

INTRINSIC VALUE

Value is determined by the future cashflows that an asset earns. In the case of stocks, it is earnings and is partially transferred to investors via dividends. In the case of property, the future cashflows come from the rental income. In bonds, it is interest income. In businesses, it is real cash generated. When an asset has no cashflow, we can safely say that it has no value. This means that in today’s context, there are many things actually being masqueraded as investments such as wine, art, watches and some may even consider gold.

The ways and means to calculate intrinsic value is called VALUATION. In the purest form, it is by discounting all the future cashflows back to the present and that determines the intrinsic value. This methodology is known as discounted cashflow or DCF.

DCF

As a start, assuming that a company generates $100 in earnings every year for the next 50 years, in the most simplistic terms, the intrinsic value is then $100 x 50 = $5000. However, we must understand that $1 next year is not the same as $1 today due to the effects of discounting. And $1 two years out is also different.

Discounting is simply reflecting that money grows over time. If we put $100 in the bank, 1 year from now, it will earn 1% and it gets to $101. If we buy a bond, we get say 3% interest and it becomes $103 next year. If we invest in a company, there is also a rate of return that this company can generate. For simplicity, the discount rate can be thought of as a minimum rate of return that this company should generate. (For more advanced readers, do note that things can be far more complexed.)

To more clearly illustrate discounting, using the bond example again, we now apply a 3% discount rate and work it backwards. So $100 next year is actually equal to $97 today because if we put $97 in the bank today, it will earn 3% interest and become $100 next year. And $100 two years out is roughly $93 today bcos if we put $93 into the bank today, it will earn 3% interest in 1 year, and both the interest and principal after Year 1 will earn another 3% interest, which brings the total to $100 two years from now.

So finally, we can now discount the future cashflows of this company back to today and calculate its intrinsic value. Recall that this company will earn $100 for the next 50 years. To make things easy, we will use the discount rate of 3% for this company although in reality it has to be much higher. This means that we add $100 + $97 + $94 + all the remaining cashflows until Year 50 and we get $2570. This $2570 is the intrinsic value for the firm.

As you may now see, we have made a few important assumptions here:

1) the company can generate $100 next year
2) the company’s earnings growth rate is zero.
3) the company will exist for 50 years.
4) the discount rate is 3%.

We cannot be sure if any of these assumptions are the right numbers ($100 or 50 years or discount rate of 3%) to use. In fact, nothing is certain with investing. Should we then apply a margin of safety to whatever intrinsic value that is calculated? The answer is yes.

VALUATION

There is a way to simplify the whole process of calculating the intrinsic value by determining only two inputs.

1) A sustainable earnings number.
2) A MULTIPLE: This is a change from the discount rate to a number called a multiple. The most popular and well-known multiple is the Price Earnings Ratio.

A sustainable earnings is different from last year’s earnings or a best estimate of next year’s earnings. Usually a rational and conservative investor would look at the average of the past few years’ earnings and determine an appropriate sustainable earnings based on the circumstances. It is also good practice for most investors to assume a slightly low-ball number based on past years’ average. When using a conservative number, we are applying the concept of margin of safety.

How does the discount rate change to a multiple? In mathematics, they are actually the same. A discount rate of 3% means a multiple of 33 times. Multiple is the reciprocal of discount rate. 1/0.03 = 33.

Similarly a discount rate of 5% translates to a multiple of 20 times and a discount rate of 10% translates to a multiple of 10 times.

Recall our example of the company generating $100 of earnings for 50 years. We get to an intrinsic value of $2570. If we drop the assumption of 50 years and believe that the firm can generate $100 perpetually, the intrinsic value actually becomes $3300. Yes, this is simply $100 / 0.03 = $3300. Or $100 x 33 = $3300. There is a mathematical proof as to why value = perpetual annual earnings / discount rate, but let’s skip that for now. So coming back, the discount rate is merely the reciprocal of the multiple.

So by applying the right multiple, we are also applying the right discount rate for the company. What is the right multiple or discount rate then? That is the ultimate question. In the last example we applied 33 times multiple, is that correct? But before we answer that, we must acknowledge that we make assumptions that may not be accurate and that investment is less science than art.

INVESTMENT ART

Since we cannot be so sure whether got the right sustainable earnings or the right multiple, we apply a margin of safety to the intrinsic value calculated. In the last example, we have calculated 2 intrinsic values: $2570 and $3300. Which is correct? As investing is an art, we are free to apply creativity here. So we can arbitrary determine that perhaps the intrinsic value is roughly $3000, and by applying a 30% margin of safety, we will buy the company only at $2000.

Some may wonder how can there be different intrinsic values if intrinsic value represents the true worth of the company. Here we need to explain using a philosophical analogy. While there is a true intrinsic value that represents the true worth of the company that does not change daily, and is the absolute truth, we, mere mortals, are incapable of determining that intrinsic value with precision. Hence we can come out with two numbers, or sometimes a range of possible numbers. These are approximations of the true intrinsic value.

This is akin to the true circle analogy in mathematical philosophy. In theory there is a true circle defined by mathematics and there is number called pi. In practice, we use our compasses in the old days and computers today to draw a circle. But this circle is after all just an approximation of the true circle that exists only in the realm of minds. And we use 3.14 to represent pi when the true pi is a number that stretches into infinite decimal places.

So similarly, there is an intrinsic value that exists that represents the absolute true worth, in theory and in the realm of minds. But we can only approximate it with our practical tools. The difference between art and science is the following: We can still pretty much draw a circle with a compass or a computer and most people on this planet would not dispute that this “o” is not a circle. Science is much more precise. We can calculate the movement of stars and draw near perfect circles. Hence we are taught to give answers to 2 decimal places.

However, in the realm of investing art, the precision we try to achieve is vague at best. Think about the masterpieces of Monet, Van Gogh and Picasso. Vague is beautiful. Perspective defines clarity. Our calculation of intrinsic value is $3000, but the true value might well be $2500, or $3500. We can derive a range of possible values but we can never pinpoint an exact number.

That is why we need the margin of safety. The margin of safety helps to ensure that we always buy below intrinsic value. Or at least we try to avoid situations where the bridge collapse (ie we lose money).

MULTIPLE

Back to our basic valuation matrix, we have :

1) a sustainable earnings number
2) a multiple

As discussed, a sustainable earnings number should be a best estimate that represents an average of what the company can earn in the future, not a single year’s number. It is also prudent to build in some conservatism ie use a lower range estimate.

The important question here is the multiple, how do we determine whether it should be 10, 20 or 33 times? The history of markets and long term analysis suggest that 12-18 times would be a good gauge for most purposes. Shiller, a professor who calculated multiple ranges using long term (10 year) average earnings came up with a range of roughly 5-40 times multiple for the US stock market over the last 100 years. During most of that time period of a century, which is incomprehensible for us mortals who cannot remember yesterday’s lunch or decide tomorrow’s dinner menu, the multiple was at 10-20 times.

This means that, if the US market as whole, is earning on average $100 per year for the last 10 years, the price is usually around $1000 to $2000. (Since the multiple is 10 to 20 times) So we have an answer to why we should use 12 to 18 times based on history, but that is not good enough. (Art is also arbitrary, 10-20 times can become 12-18 times.)

Another way to think about why we should always use a 12-18 multiple is to think about the payback period in years. If a company earns $1 per share and the share price is $30, this means that it is trading at a multiple of 30. Imagine now that we own the whole company and it generates the same earnings every year, we get back our capital in 30 years. Compare this to 12-18 times, it is roughly twice the time to get paid back our capital. Do we really want to wait 30 years to get back our capital? As it is, 12 to 18 years is an awfully long time, we shouldn’t lower our hurdle to buy something that only pay us back after 30 years.

One might be thinking that we can always have capital gain. Although the share price is $30, if it goes to $40 then we still have a profit. This is akin to a 100% business owner trying to sell his business to a greater fool who is willing to wait 40 years, instead of 30 years to get back his capital. By following such a thinking, we are not determining value. We are chasing price. If we chase prices, we are no different from all the amateur traders out there. What we are trying to do here is to determine the value of the company. Not determining if a stock at 30 times multiple can go to 40 times multiple.

Hence to recap: the value of the firm is calculated using a sustainable earnings number times its multiple. This multiple is usually 12 to 18 times.

The other analogy involves the discount rate that we discussed. Recall that the discount rate is the reciprocal of the multiple and represents a minimum rate of return that this company should generate. When we are willing to invest in companies at multiples of 30 times, it also basically means that we are happy putting money with this company can only generate a return of 3% for its investors (1/30 = 0.03). The analogy is not perfect and a deeper understanding involving the cost of capital, appropriate growth rate and terminal value is needed. But let’s keep things simple first.

Now, 3% return can be achieved by investing in risk free Singapore government bonds (20 year or more bonds). There is no need to spend an awful lot of time reading this page to learn to buy risk free government bonds. This should lead us to conclude that we should not invest in companies trading at 30 times multiple.

As investors, we should buy stocks at low multiples that can generate high returns. Hence we use the appropriate multiples of 12 to 18 times and this translates into rates of return of 5.5% to 8.3% per annum. Yes, this is the hard truth. Investment returns are not even remotely close to 50% or even 30% that we so often see in “How To Make 100% Return In 2 Months From Trading Stocks” advertisements.

Also the long term returns of different asset classes show that annual returns vary from 2-3% for risk free government bonds to 12-15% for high risk private equity or venture capital. In between we have high grade bonds at 4-6% return and properties and stocks at 8-10%. A 5.5% to 8% return falls right in the middle of this range and again represents 12-18 times as appropriate multiples.

Some may ask why not 10 times then or even 8 times. When we translate this to the rate of return, it means 10% to 12.5%, which is nearing the rate of return of the riskiest asset classes (ie. private equity or venture capital). The lower the multiple we use, the higher the rate of return required and the lesser the possibility that a stock will pass the criteria. If we apply too strict a margin of safety, we miss out genuine opportunities. Again, this exemplifies that investing is more of an art than a science. There are no golden rules that we can follow.

Another way to think of using a very low multiple is that we severely under-calculate the intrinsic value. While the true worth is $10, we keep thinking that it is $6 and we only want to buy it at $4. This is very unlikely to happen and we will fail to invest and reap rewards.

Now there are stocks that trade at 6 times multiple (like Shell in 2012) and there are stocks that trade at 100 times multiple (like Facebook in 2012). How do we explain these? The answer is that these multiples are determined using just next year’s earnings, not average earnings or sustainable earnings. This is a finance industry practice that serves little purpose for value investors.

There are also other nuances that we have not touched on, especially pertaining to earnings growth and other ways of looking at multiples. But for this session, it suffice to remember the following:

Intrinsic value = sustainable earnings x appropriate multiple

To end with an example, say a firm’s sustainable earnings is $100 and we apply an appropriate multiple of 15x. The firm’s intrinsic value is calculated as follows:

Intrinsic value = $100 x 15 = $1500

With a margin of safety at 30%, ie. we will buy if the price falls to $1000.

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