ad astra per alia porci

The 5 Keys to Value Investing
July 7, 2007, 10:14 am
Filed under: investments/finance/economics

Personal notes from The 5 Keys to Value Investing by J. Dennis Jean-Jacques

The Five Keys

  • Business
  • Value
  • Price assessment
  • Catalyst identification
  • A margin of safety determination

Good Business + Excellent Price = Adequate Return over Time

Three basic characteristics of value investors

  • They exude emotional discipline.
  • They possess a robust framework for making investment decisions.
  • They apply original research and independent thinking.

Seven fundamental beliefs

  1. The world is not coming to an end, despite how the stock market is reacting.
  2. Investors will always be driven by fear and greed, and the market will react accordingly. Volatility is simply the cost of doing business.
  3. Inflation is the only true enemy. Trying to predict economic variables is a waste of time-focus on businesses and their values.
  4. Good ideas are hard to find, bu there are always good ideas out there, even in bear markets.
  5. The primary purpose of a publicly-traded company is to convert all of the company’s available resources into shareholder value.
  6. Ninety percent of successful investing is buying right. Selling at an optimal price is the hard part. As a result, value investors tend to buy early and sell early.
  7. Volatility is not risk, it is opportunity. Real risk is an adverse and permanent change in the intrinsic value of the company.

The five keys of the value framework

  1. Is this a good business run by smart people?
  2. What is this company’s worth?
  3. How attractive is the price for this company, and what should I pay for it?
  4. How realistic is the most effective catalyst?
  5. What is my margin of safety at my purchase price?

Three approaches to analysing a business

  • Vertical assessment approach
  • ROE decomposition approach
  • Cash-flow based approach

Vertical Assessment

  • Based on a company’s income statement-moving down the statement
    • Industry analysis- what drives sales and revenue
    • Competitive position analysis
    • Manufacturing
    • Operating
    • Tax strategy assessment
    • Debt analysis
  • Industry analysis
    • SWOT analysis- strengths, weaknesses, opportunities and threats
    • Michael Porter’s five forces that drive industry profitability
      • The threat of new entrants, the threat of substitute products, the bargaining power of buyers, the bargaining power of suppliers and the degree of rivalry among competitors.
      • A company can compete through differentiation, cost leadership and focus.
  • Cost assessment
    • Cost of goods sold- look at cost variables that most impact a company’s low-cost competitive advantage
    • Operating cost control- look at trend of expenses as a percentage of sales over time.
  • Debt- value investors use interest coverage and debt-to-total capitalisation ratios.

ROE Decomposition Approach

  • ROE is the results of a company’s competitive position, operating strategies and financial flexibility. It highlights how profitably management has been able to allocate the firm’s resources.
  • (Net income/sales) x (sales/assets) x (assets/equity) = ROE
  • Return of sales x Asset Turnover x Financial leverage

Cash-Flow-Based Approach

  • Provides insight into the quality of a company’s earnings
  • Net cash flow is calculated by taking a company’s net income and adding and subtracting non-cash items.
  • Discounted cash flow method as a means of valuing a company
  • Free cash flow = a company’s net income plus noncash items, such as depreciation and amortization, minus mandatory or promised outlays of cash, such as capital expenditures.
  • A good business generates strong and consistent free cash flows that can be distributed to shareholders.

Assessing management- Economic value added approach to assess management’s ability

  • EVA = After-tax operating income – (cost of capital x capital employed)

Price and Value Assessment– 3 ways

  • Comparison based- comparison between similar companies
  • Asset based- focus on intrinsic value
  • Transaction based- assessing worth based on what other companies have been sold for in the market place

Comparison-based tools

  • P/E ratio (P/E)
  • Price to Book ratio (P/B)
  • Enterprise value to earnings before interest, tax depreciation and amortization (EV/EBITDA) – EV = Market capitalisation + Debt – Cash
  • Price to sales (P/S)
  • Enterprise value to revenues (EV/R)
  • The PEG ratio: P/E divided by expected growth rate

Asset-based Tools

  • Discounted Cash Flow
    • Three factors: cash flow, discount rate and time
    • The value of a firm is the discounted value of a firm’s cash flow
    • Free Cash Flow = Net income + Depreciation + Amortization – Capital Expenditure
    • Discount rate: either long-term Treasury rates or weighted average cost of capital (WACC)
    • WACC = E/Cap x Ec + D/Cap x Dc x (1- Tr)
    • Where E = equity market value, D = the debt market value, Cap = capitalisation, which is E+D, Ec = cost of equity, which is the returns shareholders require from the company, Dc = cost of debt, which is the returns lenders require from the company, E/Cap = equity financing as a percentage of capitalisation, D/Cap = debt financing as a percentage of capitalisation, Tr = the company’s tax rate
    • Time period – most investors use 5 to 7 years
    • Shortcomings of DCF – does not work well with cyclical, acquisitive or restructuring companies – low values for these companies

Transaction-based Tools

  • Relies on the values that the acquired company places on a firm’s assets.
  • Searches aggressively for prior transactions of similar businesses.

Catalyst Identification and Effectiveness

  • Internal catalysts
    • New management installed
    • Company employs a new corporate strategy
    • Company implements new product strategy
    • Improved operational efficiencies
    • Cutting costs
    • New financial strategy
    • Sustained tax rate reduction
    • Reducing working capital can free up cash
    • Reducing capital investments to create value
    • Share buybacks
    • Spin-offs and equity carve outs
    • Split-offs
    • Asset sale and use of proceeds
    • Full or partial liquidations
  • External catalysts
    • The presence of shareholder activists
    • Industry merger activity
    • Time- bad things come to an end

The “Margin of Safety” Principle

  • Margin of safety as essentially the gap between price and value
  • Buying companies with a margin of safety prevents owning companies with a high burden of proof to justify their stock valuations.
  • Investors employ qualitative and quantitative reasoning.
  • Quantitative reasoning
    • Graham buys companies at net-net values: a pirce equal to the firm’s current assets minus all liabilities, giving very little value to plant, property and equipment.
    • At the core of analysing a firm quantitatively is the assessment of the cash-generating possibilities of its assets.
    • Liquidation value – use with a declining industry
    • Replacement value – normal industry
    • Book value assessment
  • Qualitative reasoning
    • Involves the determination of the value of intangible assets, like brand name and goodwill
    • Using private market valuations as a proxy to determine public market value.
    • Getting something for free- see if the public markets do not value an important asset
    • Dividend yield factor- a source of safety
    • Historical perspective- how a company has faired in a market

Risk and Uncertainty

  • Risk is quantifiable but uncertainty is not.
  • How to approach risk
    • Total Investment Risk = Basic Business Risk + General Market Risk

Assessing the Investment Opportunity

  • Identifying the opportunity- seven types
    • Event-driven
    • Cyclical
    • Temporarily-depressed
    • Modest/slow growth in line with economy
    • High growth
    • Hybrid
    • Value-traps

When to Sell

  • Fundamental deteriorate
  • Price has reached its fair value
  • Catalyst failed to materialise or to be effective

1 Comment so far
Leave a comment

Nice summary. Easier said than done, agree?

Comment by ValueHuntr

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: