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)

2

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

3

Real S&P 500 and Trend

4

5

6

7

8

9

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)

10

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.

11

Value Investing the Approach

Value

Review

Manage Risk

Search (Look systematically for undervaluation)

12

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

13

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

14

15

16

17

Systematic Biases

1. Institutional

Herding – Minimize Deviations

Window Dressing (January Effect)

Blockbusters

2. Individual

Loss Aversion

Hindsight Bias

Lotteries

18

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

19

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

20

Value Investing the Approach

Value

Review

Manage Risk

Search (Look systematically for undervaluation)

21

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%+)

22

Valuation Approaches Net Present Value of Cash Flow

Value = CFt = CF0 1

1 + 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

23

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

20 1

+ ...

Good

Information

(Precise)

Bad Information

(Imprecise)

= Bad/Imprecise Information

Profit

Margin

Cost of

Capital

Growth

Required

Investment

24

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

25

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 Growing Competitive

Advantage Advantage

26

Basic Elements of Value

Strategic Dimension

Growth in Franchise Only

Franchise Value

Current Competitive Advantage

Free Entry

No 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

27

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 ?

28

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 Value Basic Graham-

Dodd Value

29

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

30

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 trends

Real estate

Intangibles

• M/B indicator close to M/Repro value

• Improvement requires discipline

• Value = Zero (except NWC)

31

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)

32

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

1

Cost of capital *

33

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).

34

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

35

Earning Power and Entry - Exit

Asset Value EP Value

Case B: Free Entry

Industry

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

36

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

37

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

38

“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%

39

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)

40

Summary of Valuation Strategic 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?

41

Basic Strategy Framework Porter Five Forces – Probability Determinants

Four Forces too many

Substitutes

Customer Suppliers

Entrants

Industry

Competition

42

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

43

Consequences of Free Entry

Commodity Markets (Steel)

$/Q

Q Firm Position

Price

AC “Economic Profit”

ROE (20%) > Cost

of Capital

Entry/Expansion

Supply Up, Price

Down

$/Q

Q Firm Position

Price

AC

(Efficient Producers)

ROE = 12%

No Entry

No Profit

44

Consequences of Free Entry

Differentiated Markets (Luxury Cars)

$/Q

Q Firm Position

Demand Curve

AC “Economic Profit”

ROE (20%) > Cost

of Capital

Entry/Expansion

Demand for Firm

shifts left (Fewer

sales at each

Price)

$/Q

Q Firm Position

Demand

Curve

AC

ROE = 12%

No Entry

No Profit

45

Barriers to Entry Incumbent 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

46

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

47

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)

48

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)

49

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

50

Other Barriers-to-Entry

• Government, Regulatory, Public

(Lead based Gas Additives; Cigarettes)

• Informational (Who Knows What)

(Banks, Financial Services, HMO’s)

51

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?

52

Performing Strategic Analysis

Apple Computer - Industry Map

Industry:

• Identify Segments Step 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

53

Performing Strategic Analysis

Do Barriers/Competitive Advantage Exist

54

Performing Strategic Analysis

Nature of Barriers-to-Entry Competitive Advantage

55

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)

56

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

57

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)

58

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

59

Value of Growth - Basic Algebra

60

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 - 0

R-G 10 - 0 = = 1 G = 0%

ROC – G 10 - 2

R-G 10 - 2 = = 1 G = 2%

ROC – G 10 - 8

R-G 10 - 8 = = 1 G = 8%

e.g. (ROC = R =

10%)

=

61

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 - 0

R-G 10 - 0 = = .8 G = 0%

ROC – G 8 - 2

R-G 10 - 2 = = .75 G = 2%

ROC – G 8 - 8

R-G 10 - 8 = = 0 G = 8%

e.g.

(ROC = 8%, R=10%)

62

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 - 0

R-G 10 - 0 = = 1.5 G = 0%

ROC – G 15 - 2

R-G 10 - 2 = = 1.625 G = 2%

ROC – G 15 - 8

R-G 10 - 8 = = 3.5 G = 8%

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

10%)

63

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

64

Valuing Growth - How much Does it

Add?

65

Valuing Growth

High (Unstable) Growth

66

Valuing Growth

Breakeven Growth Rate

67

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

68

Summary of Valuation

Value

Review

Manage Risk

Search (Look systematically for undervaluation)

69

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

Asset

Value

EP

Value

Growt

h

Value

MV < AV,

EPV

AV < MV <

EPV

AV, EPV <

MV

BUY Assess Comp.

Adv.

Lots of

Luck

Lots of

Luck

BUY

Sustainable?

No Yes

Most

certain

but mgt.?

Medium

certain

Sustainable?

Uncert

ain

71

Summary of Valuation

Strategic Dimension

Growth in Franchise Only

Franchise Value

Current Competitive

Advantage

Free Entry

No 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