1

Approaches to Investing

Long Term Short Term Efficient Market

Fundamental(Value)

Levels

• Mkt. Price vs. Value

We Are Here

Fundamental(Value)

Technical

• Momentum

• Price/Volume Patterns

Changes

• Current Price + Forecast Change

• Micro

• Macro

• Asset Allocation

• Cost Minimization

Relative Rarely Done Well(Shliefer, Vishny, Lakonishok)

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Essentials of Value InvestingLong-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

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Real S&P 500 and Trend

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Value Investing in Practice

1) Look Intelligently for Value Opportunities (low P/E, M/B)

2) Know What You Know

3) You Don’t Have to Swing

• Value Implies Concentration not Diversification (look for Margin of Safety)

• At Worst, Buy the Market

• Not All Value is Measurable

• Not All Value is Measurable By You (Circle of Competence)

• Mr. Market is not Crazy about Everything

• This is the first step not to be confused with Value Investing

Long-Term Fundamental (Look at Underlying Businesses)

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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)

15%Value

Terminal Value

(depends on conditions in 2010 & beyond)

Valuation:

2000 2010

Dividends

85%Value

Value = current price (i.e. 110) 80x earnings.

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Value Investing the Approach

Value

Review

Manage Risk

Search(Look systematically for undervaluation)

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Search Criteria

• Obscure −Small Capitalization−Spin-Offs−Boring (Low Analyst Coverage)

• Undesirable

• Supply, Demand Imbalance - RTC

−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)

−Privatizations

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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

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Systematic Biases

1. Institutional

Herding – Minimize Deviations

Window Dressing (January Effect)

Blockbusters

2. Individual

Loss Aversion

Hindsight Bias

Lotteries

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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

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Summary of Search

Value

Review

Manage Risk

Search(Look systematically for

undervaluation)

• Low M/B, P/E, Growth

• Disappointing Rtns

• Institutional Psycho

• Logical Rationale

• Obscure

• Undesirable

• Supply-Demand Imbalance

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Value Investing the Approach

Value

Review

Manage Risk

Search(Look systematically for undervaluation)

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Valuation Approaches – Ratio Analysis

Cash Flow Measure

Earnings

(Maint. Inv. = Depr + A)

EBIT

(Maint. Inv. = Depr + A; Tax =0)

EBIT - A

(Maint. Inv. = Depr only)

EBIT-DA

(Maint. Inv. = 0)

Multiple

Depends on:

• Economic position

• Cyclical situation

• Leverage

• Mgmt. Quality

• Cost of Capital (Risk)

• Growth

x

Range of Error (100%+)

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Valuation ApproachesNet Present Value of Cash Flow

Value = CFt = CF0

11 + R( )t 1

R - g *

t=0

Note: NPV Analysis encompasses ratio analysis(NPVdiseases are ratio analysis diseases)

Note: NPV is theoretically correct

Revenues

Margins

Required Investments

Investment

Cash Flows

Cost of Capital

NPV </> Market Value

Parameters:

Market Size

Market Share

Market Growth

Price/Cost

Tech

Management Performance

Forces:

Consumer Behavior

Competitor Behavior

Cost Pressures

Technology

Tech

Management Performance

In Practice:

X

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Shortcomings of NPV Approach in Practice(1) Method of Combining Information

(2) Sensitivity Analysis is Based on Difficult-to-Forecast Parameters which co-vary in fairly complicated ways

NPV = CFo +CF1

1

1 + R 1 + R+ … +CF20

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1+ ...

Good Information (Precise)

Bad Information (Imprecise)

= Bad/Imprecise Information

Profit Margin

Cost of Capital

Growth

Required Investment

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Valuation Assumptions

Traditional:

• Profit rate 6%

• Cost of capital 10%

• Investment/sales 60%

• Profit rate +3% (i.e. 9%)

• Growth rate 7% of sales, profits

Strategic:

• Industry is economically viable

• Entry is “Free” (no incumbent competitive advantage)

• Firm enjoys sustainable competitive advantage

• Competitive advantage is stable, firm grows with industry

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Value InvestingBasic 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 Growing CompetitiveAdvantage Advantage

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Basic Elements of Value

Strategic Dimension

Growth in Franchise Only

Franchise ValueCurrent Competitive Advantage

Free EntryNo Competitive Advantage

Asset Value Earnings Power Value

Total Value

• Tangible• Balance Sheet

Based• No

Extrapolation

• Current Earnings

• Extrapolation• No Forecast

• Includes Growth

• Extrapolation• Forecast

Reliability Dimension

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Industry Entry - Exit

Remember, Exit is Slower than Entry.

Industry Market Value Net Asset Value Entry

Chemicals $2B $1B Yes (P MV )(Allied) $1.5B $1B Yes

$1.0B $1B Stop

Automobiles $40B $25B Yes (Sales MV)(Ford) $30B $25B Yes

$25B $25B Stop

Internet $10B $0.010B ?

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Asset Value

Assets

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

Reproduction ValueBasic Graham-

Dodd Value

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Asset Value Approaches

Remember, Low M/B is very hard to beat.

Opportunities None Limited More Extended

Value in Practice Yes Yes Yes

Industry Knowledge None None Extensive

Stability/Reliability High Low Intermediate

Goodwill 0 Historical Reproduction

Debt Book Book Est Market(Low Debt) (0 Enterprise) (0 Enterprise)

Approach Graham Book Reproduction

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Asset Value Issues

• Management

• Private Market Values

• Reproduction vs. Book

• Non Viable Industries

• Good adds value

• Bad subtracts value

• Potentially highly unstable (EBITDA multiples of Internet subs)

• Better where accountants misestimate

Tech trendsReal estateIntangibles

• M/B indicator close to M/Repro value

• Improvement requires discipline

• Value = Zero (except NWC)

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Asset Value Risk Management

• Private biases

• Catalysts

• Importance of industry knowledge

• Hedging

• Personal computer industry

• Psychological experiments

• Evidence of investment behavior in life

• Takeover

• Reorganization

• Management change

• If don’t know, don’t play (Circle of Competence)

• Limited

Ultimately, “Margin of Safety” is risk management tool

(Otherwise diversify)

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Earning Power Value

Basic Concept – Enterprise value based on this years “Earnings”

Measurement

– Earnings Power Value = “Earnings”

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

1Cost of capital*

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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).

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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

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Earning Power and Entry - Exit

Asset Value EP Value

Case B: Free EntryIndustry Balance

Case A:

Asset Value EP Value

Value Lost to Poor Management and/or Industry Decline

Asset Value EP Value

Case C: Consequence of Comp. Advantage and/or Superior Management

“Sustainability” depends on Continuing Barriers-to-Entry

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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

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Earnings Power Value Issues

Nature and sustainability of barriers-to-entry (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

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“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%

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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 Fractionof Franchise Value (1000M-500M)

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Summary of ValuationStrategic vs. Traditional Approach

Market Size Estimate

Market Share

Operation Margin

Investment

Cost of Capital

Value

Traditional

Revenue

Oper Income (EBIT)

Cash Flow

NVP

National Income,Growth, Consumer Trends

Competitive Responses; Entry/Exit

Technology, Costs;Prices; Input Costs

Technology, Growth

Financial Market Conditions; Risks

Strategic: Is this the South Bronx of the Investment World?

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Basic Strategy FrameworkPorter Five Forces – Probability Determinants

Four Forces too many

Substitutes

CustomerSuppliers

Entrants

Industry Competition

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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

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Consequences of Free EntryCommodity Markets (Steel)

$/Q

QFirm Position

Price

AC “Economic Profit”

ROE (20%) > Cost of Capital

Entry/Expansion

Supply Up, Price Down

$/Q

QFirm Position

Price

AC

(Efficient Producers)

ROE = 12%

No Entry

No Profit

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Consequences of Free EntryDifferentiated Markets (Luxury Cars)

$/Q

QFirm Position

Demand Curve

AC“Economic Profit”

ROE (20%) > Cost of Capital

Entry/Expansion

Demand for Firm shifts left (Fewer sales at each Price)

$/Q

QFirm Position

Demand Curve

AC

ROE = 12%

No Entry

No Profit

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Barriers to EntryIncumbent Cost Advantage

Entrant Incumbent Sources

No “Economic” Profit

ROE = 12%

No Entry

“Economic” Profit

ROE = 20%

Proprietary Tech(Patent, Process)

Learning Curve

Special Resources

• Not Access to Capital

• Not Just Smarter

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Barriers to Entry

Incumbent Demand Advantage

Entrant Incumbent Sources

No “Economic” Profit

ROE = 12%

No Entry

Higher Profit, Sales

ROE = 20%

Habit (Coca-Cola)

• High Frequency Purchase

Search Cost (MD’s)

• High Complex Quality

Switching Cost (Banks, Computer Systems)

• Broad Embedded Applications

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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)

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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)

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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

•Cost efficiency in “Own” technology

•No advantage with virgin technology

•Shrinkage with technology change

Static Cost Advantages

Economies-of-Scale + Dynamic Demand Advantage

• Principal sustainable advantage

• Constant vigilance

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Other Barriers-to-Entry

• Government, Regulatory, Public

(Lead based Gas Additives; Cigarettes)

• Informational (Who Knows What)

(Banks, Financial Services, HMO’s)

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Performing Strategic Analysis

Industry Map

Do barriers Exist?

What Competitive

Advantages?

Future Strategy, Profitability

(1)

(2)

(3)

(4)

Identify Industry

Industry History

Demand? Cost? Economies-of-Scale?

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Performing Strategic AnalysisApple Computer - Industry Map

Industry:

• Identify SegmentsStep 1:

For Apple Segment Are:• Chips• Hardware• Software

Step 2:

Step 3:

Chips

Components

Hardware Software Networks

Intel, AMD, Motorola, Apple

Dell, HP, Gateway, IBM, Compaq, Apple

Microsoft, Apple, Oracle, Netscape

AOL

Power Supply Co.’s, etc.

• Identify firms in each segments

• 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

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Performing Strategic Analysis

Do Barriers/Competitive Advantage Exist

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Performing Strategic Analysis

Nature of Barriers-to-Entry Competitive Advantage

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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)

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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

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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)

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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

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Value of Growth - Basic Algebra

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Valuing Growth

Case 1: ROC Return on Capital Cost of Capital R Then ROC – G R – G

R – G R – G= 1 (for all growth rates)

ROC = R when there are no Barriers-to-Entry (i.e. no competitive advantages – level playing field) then Growth has no Value.

ROC – G 10 - 0R-G 10 - 0

= = 1 G = 0%

ROC – G 10 - 2R-G 10 - 2

= = 1 G = 2%

ROC – G 10 - 8R-G 10 - 8

= = 1 G = 8%

e.g. (ROC = R = 10%)

=

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Valuing Growth

Case 2: Competitive disadvantage with growth

ROC less than cost of capital then ROC – G < R - GROC – G < 1

R – G and ROC – G gets smaller with higher growth rates.

R – G

Higher Growth at a Competitive

Disadvantage Destroys Value

ROC – G 8 - 0R-G 10 - 0

= = .8

G = 0%

ROC – G 8 - 2R-G 10 - 2

= = .75 G = 2%

ROC – G 8 - 8R-G 10 - 8

= = 0 G = 8%

e.g.

(ROC = 8%, R=10%)

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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

Only within Franchise Growth creates Value

ROC – G 15 - 0R-G 10 - 0

= = 1.5 G = 0%

ROC – G 15 - 2R-G 10 - 2

= = 1.625 G = 2%

ROC – G 15 - 8R-G 10 - 8

= = 3.5 G = 8%

e.g. (ROC = 15%, R = 10%)

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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

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Valuing Growth - How much Does it Add?

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Valuing GrowthHigh (Unstable) Growth

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Valuing Growth Breakeven Growth Rate

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Valuing GrowthKeep-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

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Summary of Valuation

Value

Review

Manage Risk

Search(Look systematically for undervaluation)

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Managing Risk – Overall Valuation

Review biases

Look for asset protection

Adequate margin of safety (1/3)

Identify catalysts (create catalysts?)

Appropriate search rationale

70

Summary of Valuation

AssetValue

EPValue

Growth

Value

MV < AV, EPV

AV < MV < EPV

AV, EPV < MV

BUY Assess Comp. Adv.

Lots of Luck

Lots of Luck

BUY

Sustainable?

NoYes

Most certain

but mgt.?

Medium certain

Sustainable?

Uncertain

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Summary of Valuation

Strategic Dimension

Growth in Franchise Only

Franchise ValueCurrent Competitive Advantage

Free EntryNo Competitive Advantage

Asset Value Earnings Power Value

Total Value

• Tangible• Balance Sheet

Based• No

Extrapolation

• Current Earnings

• Extrapolation• No Forecast

• Includes Growth

• Extrapolation

• Forecast

Reliability Dimension