Introduction
- Value investor primary goal is preservation of capital, they seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time
- The most beneficial time to be a value investor is when the market is falling
- Buffet “value investing is not a concept that can be learned and applied gradually over time. It is either absorbed and adopted at once, or it is never truly learned.”
Chapter 1: Speculators and unsuccessful investors
- Investors expect to profit from three ways: free cash flow generated, increase in multiple, and narrowing of the gap between share price and underlying business value
- Speculators buy and sell securities based on whether they believe securities will rise or fall in price
- Investments throw off cash flow for the benefit of the owners, speculations do not
- Collectibles are not investments but speculations because they do not generate cash flow
- Successful investors are unemotional, they respond to market forces with calculated reason
- Louis Lowenstein “Do not confuse the real success of an investment with its mirror of success in the stock market”
- Value investors look to Mr. Market as a creator of investment opportunities (price departs from underlying value)
- Investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process
Chapter 2: The Nature of Wall Street Works Against Investors
- Wall Street is plagued by conflicts of interest and short-term orientation
- IPO market is very overpriced and frequently involves the use of financial engineering to generate commissions and underwriting fees for the Wall Street banks
- Closed-end funds charge high commissions and their value can fall below NAV while open-end no load mutual funds always trade at NAV
- In the late 80’s high demand for closed-end country funds resulted in many trading much higher than their NAV, they all came crashing down a few years later
- Wall Street has a bullish bias as it generates more fees for them. Regulators also have a bullish bias
- Wall Street’s supply of investible products increases until it exceeds market demand. All of these new products were created with a short-term perspective and may not have served their purpose in the medium to long term
- Wall Street created IO (interest only) and PO (principal only) MBS that did not trade in tandem and sometimes traded at a discount to from the theoretical underlying value
- Wall Street also creates investment fads that are hard to distinguish from a real business trend
Chapter 3: The Institutional Performance Derby – The Client is the Loser
- A 1979 US Department of Labor ruling led to riskier portfolios of securities being created for institutional investors. No longer was each investment scrutinized on an individual basis for risk (prudent man)
- Today institutional investors account for more than ¾ of stock exchange trading volume. Understanding their behavior is helpful in understanding why certain securities are overvalued while others are undervalued
- Money managers have an incentive to increase and maintain AUM, this puts them at odds with their clients and results in mediocre performance
- Relative performance compares short term investment results against peers and indices this causes money managers to lose long term focus
- Few money managers invest in their own funds which puts them at odds with the interests of their clients
- Institutional investors with innovative or contrarian ideas are often afraid to speak out in fear of losing their jobs, thus time is loss in the bureaucratic decision making process and some great investments are never bought or sold
- Selling investments is difficult for money managers because many investments are illiquid, selling creates additional work as proceeds must be reinvested, and the SEC looks unfavorably on portfolio turnover for mutual funds
- The top-down view portfolio managers take can sway analysts a certain way and impact investment decisions
- There are diseconomies of scale in the returns earned on increasingly large sums of money under management because good investment ideas are in short supply
- Many funds self impose constraints on themselves to remain fully invested at all times. This does not meet the standard of an absolute performance orientated investor who may find there are some times where it is best to be in cash
- When money managers overly categorize what they are allowed to invest in they are missing out on investment opportunities that may offer a similar risk-reward profile
- Some money manager window dress their portfolios for quarterly reporting purposes by selling out of favor investments and purchasing high performing investments. This exacerbates price movements and provides little benefit to clients
- Recently money managers have abandoned fundamental analysis entirely and now depend on indexing. The efficient-market hypothesis and capital-asset-pricing model support this strategy
- The Portfolio Insurance technique of selling stock index futures when an index loses 3% turned out disastrous as futures became significantly more undervalued than the index. This resulted in arbitrageurs stepping in a furthering the problem.
- Tactical Asset Allocation determines when it is a better time to be invested in bonds and when to be invested in stocks. There are too many variables to consider to incorporate tactical asset allocation into a computer program
- Indexing has gained in popularity and is practiced by managers that believe in the efficient market theory. However, this has resulted in managers less concerned with their performance as they can use the index as an excuse also as more and more managers index it becomes less effective
- Exploring investment opportunities that are excluded from institutional investors can be rewarding because they have so many self-constraints
Chapter 4: Delusions of Value: The Myths and Misconceptions of Junk Bonds in the 1980s
- Michael Milken popularized the junk bond by arguing that a diversified portfolio of junk bonds had a greater risk-reward profile that a portfolio of similar investment grade bonds. The central theme to his argument was that the high yields of the junk bonds overcompensated for their default losses. He was the initial provider of liquidity to this market and was able to convince investors that new-issue junk bonds provided the same risk-reward profile as fallen-angel or existing issue junk bonds.
- The default rate of junk bonds during this time was masked by increasing number of new-issue bonds coming to market, the use of non-cash-pay securities, and issues that went through impairment
- Junks bonds were looked upon as saviors of America as they were able to fund small businesses, create jobs, and increase the US’s competitiveness. Soon takeover artists were using junk bonds to finance purchases of some of the largest companies in America.
- The improving economy of the 1980s increased both issuers and investors appetite for junk bonds, however by the end of the 1980s interest-coverage ratios fell below 1 and the ratio of debt to net tangible assets grew threefold
- Junk bond mutual funds were forced to add lower and lower quality bonds to their portfolios in order to show the best yield and attract assets
- Thrifts and insurance companies also felt compelled to invest in junk bonds
- Zero-coupon and PIK bonds permitted recklessness while interest rate resets were shown to be unsuccessful
- The shift of investor focus from after-tax earnings to EBIT and then EBITDA masked important differences between businesses. These new valuation metrics were used to justify high prices paid for highly-leveraged companies
- Rating agencies assigned investment grade ratings to senior junk-bond traunches which made them seem safer than their underlying assets
- By the 90s the junk bond fad was over and prices came crashing down. Junk bonds effected all of the financial markets and costs investors a load of money
Chapter 5: Defining You Investment Goals
- If you are a risk adverse investor than loss avoidance should be a cornerstone of your investment philosophy
- Risk avoidance is not the primary focus of most institutional investors because clients sometimes value short term outperformance over long term consistent returns
- Rather than targeting a desired rate of return, investors should target risk
Chapter 6: Value Investing and the Importance of a Margin of Safety
- Value investing is buying securities at a significant discount from their current underlying value and holding them until more of their value is realized (buying a dollar for fifty cents). Requisite to buy only when a sufficient discount from the underlying value is available
- The disciplined pursuit of bargains makes value investing a risk-averse approach
- Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds
- A value investor may experience poor performance during prolonged periods of market overvaluation, but over the long run the value approach is extremely successful
- Value investors will not invest in businesses that they cannot readily understand or ones they find excessively risky
- Value investors continually compare potential new investments with their current holdings in order to ensure that they own only the most undervalued opportunities available
- The “credit cycle”, the periodic tightening and relaxation of the availability of credit has a significant impact in the volatility in business value
- Trends in inflation and deflation also impact business values; real estate and natural resource properties increase in value with inflation while companies with “hidden assets” like overfunded pension plans or financing subsidiaries perform well when prices are going down
- Valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value
- A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world
- Investors must give preference to tangible assets over intangible assets (tangible assets can perform other functions if the business goes bust, while intangibles cannot)
- Value investors must be comfortable with holding cash until attractive investments come available
- It is critical to know why you have made an investment and to sell when the reason for owning no longer applies, look for catalysts that may assist directly in the realization of underlying value. Give preference to companies with good management that have personal financial stakes in the business
- Value investing shines in down markets as investors finally begin to examine valuations
- It is not hard to realize how the efficient market hypothesis is wrong when few if any research analysts follow small-cap, distressed debt, and less-popular investments. This allows for the value disconnect to occur
- Mispricings occur for a variety of reasons including certain rules and standards firms must follow to continue to operate
- There are many value pretenders that claim to practice the principles but rapidly change strategies when it fits them most
Chapter 7: The Root of a Value-Investment Philosophy
- Top-down investing depends on many macro-economic factors that may or may not become true and relies on the expectations of others
- A value investor employs a bottoms-up approach where individual investment opportunities are identified one at a time through fundamental analysis. The entire strategy can be concisely described as “buy a bargain and wait.”
- Value investors do not attempt to time the market and hold cash until valuable investment opportunities occur
- The uncertainties value investors face: what is the underlying business worth, will that underlying value endure until shareholders can benefit from its realization; what is the likelihood that the gap between price and value will narrow, and what is the potential risk and reward
- A value investor is only concerned with absolute performance and does not concern himself with the returns of other investors or that of the overall market
- A value investor analyzes risk and return independently for every investment
- Risk is dependent on both the nature of the investments and the market price
- Risk is a perception in each investor’s mind that results from analysis of the probability and amount of potential loss from an investment
- Value investors invest at discount (margin of safety) because they can never be sure of the risks of an investment
- Beta is a poor measure of risk because past security price volatility does not reliably predict future investment performance or volatility
- Short-term price fluctuations do not always matter to long term investors unless they provide an opportunity to deploy cash, the company runs into some fundamental trouble, or the investors are forced to sell a certain security
Chapter 8: The Art of Business Valuation
- NPV and IRR calculation are only as good as the cash flow assumptions used. They should only be used when valuing bonds when the contractual payments are certain
- No company can be valued precisely. For the value investor the price paid must be less than the value of the company.
- Ways to value a business: Going concern value (NPV), liquidation value, stock market value- must consider the value of each subsidiaries separately
- Since it is impossible to be perfectly accurate on future cash flows value investors practice conservatism in their valuations
- A discount rate is the rate of interest that would make an investor indifferent between present and future dollars
- The underlying risk of an investment’s future cash flows must be considered in choosing the appropriate discount rate. It is essential that investors choose discount rates as conservatively as they forecast future cash flows
- Analyzing the cash flows of the underlying business is the best way to value a stock
- It is important that investors perform sensitivity analysis where the evaluate the effect of different cash flow scenarios and different discount rate on present value
- Private market values can be inflated due to use of non recourse junk debt it is best to use private market value as one of several inputs in the valuation process
- The liquidation value of a business is the value of its tangible assets. When a stock is selling below this level it is frequently an attractive investment
- Breakup value involves determining the highest value of each component of a business, either as an ongoing enterprise or in liquidation
- During a firesale liquidation inventory and receivables should be significantly discounted but during an orderly liquidation current assets may be worth book value (inventory may be worth less than book value depending on the stage of inventory). It is more difficult to determine the value of long-term assets
- Benjamin Graham preferred net net working capital to determine the liquidation value of a business (current assets – current liabilities – all long term liabilities)
- Corporate liquidations are great opportunities for value investors as the underlying value of the business is finally discovered
- Stock market value is only useful in a limited number of circumstances (valuing a closed-end mutual fund)
- Reflexivity between the market price of a stock and the underlying value of the business does exist but should only be a minor consideration (low stock prices make it impossible to raise more capital or refinance)
- Investors must be hesitant to use earnings as a valuation metric as they can be massaged by management to make the business appear more profitable that it actually is.
- Book value is the historical accounting of shareholders equity, what’s left after liabilities are subtracted from assets. Book value is not an accurate valuation tool because the carrying cost of assets can be very different than their actual worth. Also dividend recapitalizations and M&A accounting can have an effect on book value
- Do not value a company by its dividend yield as many struggling companies offer strong dividends with high yield because of declining share prices
Chapter 9: Investment Research – The challenge of finding attractive investments
- The three specialized niches of value investing: securities selling at a discount to breakup or liquidation value, rate-of-return situations, and asset conversion opportunities
- Risk arbitrage and complex securities can enable investors to calculate expected rates of return and may be worth of investing in
- Asset conversions include distressed and bankrupt securities, corporate recapitalizations, and exchange offers
- Investors must realize when an investment is a bargain through institutional constraints that have no real impact on the underlying value of the business
- Obscurities and thin markets cause stocks to sell at depressed levels, as does year end tax-loss selling
- Value investing is sometimes contrarian. Investors should not be swayed by opinions but rater use them to receive better values
- The value of in-depth fundamental analysis is subject to diminishing marginal returns. Investors will never have the 100% complete picture on the health of a company
- Business information is highly perishable. Investors must be comfortable making decisions without complete information.
- Investors need to be aware of the motivations of management. Insider buying could be a great indication of management’s ability to narrow the gap between value and share price
- Insider information laws are vague and until there is more clearance investors should tread carefully
Chapter 10: Area s of Opportunity – Catalysts, Market inefficiencies, and institutional constraints
- Owning securities with catalysts for value realization is an important way to reduce the risk with their portfolios, augmenting the margin of safety achieved by investing at a discount
- Investing is liquidations can provide great value if investors have patience to go through the liquidation process
- Complex securities can provide great value as many investors are unfamiliar with and unable to put a valuation on them
- Rights offering allow existing share holders to maintain proportional ownership in a company. Share holders have a strong incentive to participate. Investors can make a quick profit buying the rights offerings of those investors who chose not to participate
- Certain risk-arbitrage situations can result in unique investable opportunities. The complexity of the required analysis limits the number of capable participants
- Spinoffs usually initially trade at depressed market prices and can become an opportunity
Chapter 11: Investing in Thrift Conversions
- After thrift deregulation in the 80’s the rate on deposits rose above the yield on thrift assets resulting in a negative interest rate spread. Thrifts began engaging in more risky lending and investing activity which resulted in many becoming insolvent
- In a thrift conversion there are no outstanding shares and the funds raised in the IPO are added to the preexisting capital of the institution. The public also has the opportunity to buy shares at the same price as insiders in the thrift (only applies to thrifts with positive pre-conversion values)
- Investing in thrift conversions can be rewarding but careful analysis is crucial
Chapter 12: Investing in Financially Distressed and Bankrupt Securities
- Bankrupt securities sell considerably below par value where the risk/reward ratio can be attractive for knowledgeable and patient investors
- The operations of capital-intensive businesses, over the long run, are relatively immune from financial distress while those that depend on public trust or an image may be damaged irreversibly
- Capital structure is important when reviewing distressed companies. Overleveraged holding companies can file for bankruptcy protection while their operating subsidiaries are unaffected
- An exchange offer is an attempt by a financially distressed issuer to stave off bankruptcy by offering new, less-onerous securities in exchange for some or all of those outstanding
- Exchange offers are difficult to complete as they involve persuading bond or preferred stock holders to accept less than one dollar’s worth of new securities for every dollars worth of claim they currently hold
- Bondholders cannot force the minority bondholders to accept an exchange offer. This results in an exchange somewhat like the prisoner’s dilemma where neither side accepts the exchange offer (free-rider problem where it is best to hold-out)
- Pre-packaged bankruptcies hope to overcome the free-rider problem by planning out the reorganization of a company prior to the bankruptcy filing. Negotiations between bondholders are made and a majority of each creditor class must approve a bankruptcy plan
- For a bankruptcy plan to be confirmed, the plan must be approved by the bankruptcy judge as well as by a majority in number and two-thirds in dollar amount of each class of creditors
- Bankrupt companies tend to buildup substantial cash balances which helps them devise a plan of reorganization (slimming down and delaying payouts)
- Investing in bankrupt businesses can bring liquidity to illiquid investment holdings (cash, new equity or debt)
- There are three stages of bankruptcy: the first is immediately after the company files chapter 11 and the company is in turmoil, the second is during the negotiation of a plan of reorganization, the third occurs between the finalization of a reorganization and the debtor’s emergence from bankruptcy
- Timing is important when investing in bankrupt securities. Traders can take advantage of unsophisticated investors in the illiquid bankruptcy market
- The first step in investing in bankrupt securities is to understand the company’s balance sheet and off balance sheet assets and liabilities 1. How the assets are to be valued and divided 2. The seniority of the liabilities and the risk reward payoff of each liability
Chapter 13: Portfolio Management and Trading
- When investors do not demand compensation for bearing illiquidity, they almost always come to regret it
- Duration is a mitigating factor in the tradeoff between return and liquidity. The shorter the duration the less an investor needs to be compensated for illiquidity
- The portfolio liquidity cycle involves starting with liquidity (cash) investing in a less perhaps less liquid product (value investment) and selling the investment and converting back to cash and liquidity
- Portfolio cash flow can reduce and investor’s opportunity costs and allows the portfolio managers to challenge themselves to put the cash to work and seek out the best values
- Portfolio diversification is necessary to reduce risks but over-diversification is no better than indexing. Proper diversification is about owning securities that have different risk characteristics and profiles
- Market risk cannot be reduced through diversification but can be limited by proper hedging. When the risk – reward profile of an investment is sufficient an investor should remain unhedged, otherwise an investment with valuable hedging properties could be an attractive investment on its own merits
- Buy and store away investing is no longer relevant in the marketplace, even fundamental investors should be in touch with the market in order to discover pricing discrepancies
- Investors should consider whether they want to “average down” in a particular investment and buy more at a lower price. If in investor does not want to average down it is possible that the investment is not the right one to make
- The decision to sell depends on the current price of the investment versus its underlying value (Is it still a bargain?) and what other investment opportunities are available
Chapter 14: Investment Alternatives for the Individual Investor
- The share price of open ended funds is always equal to net asset value, which is based on the current market prices of the holdings
- One of the best ways to evaluate a money manager is to ask whether they invest their personal money alongside investors. This is a true testimony to confidence
- Choose money managers with a long record of success through diverse business cycles.
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