On May 13, 2017, I gave a talk in Beijing about value investing. I started with some explanation on the theory then gave some examples of the thought process behind some value investments I’ve made in the past. This post is Part 2. Part 1 is here. Feedback is most welcome!
Value Investing: An Overview – Part II
Disclaimer: Nothing in this post should be considered investment advice. This post is meant to be informative and educational about value investing.
An Investment Operation
Benjamin Graham in The Intelligent Investor noted there are two kinds of investing operations: speculative operations and investment operations.
“An investment operation is one in which, upon thorough analysis promises safety of principle and an adequate return. Operations not meeting these requirements are considered speculative.” – Benjamin Graham (The Intelligent Investor)
In my humble opinion, any investment operation that seeks to be successful must aim for the two goals simultaneously: capital preservation (safety of principle) and satisfactory returns (adequate return). In Graham’s quote above (and I agree wholeheartedly) the way an investment operation attains these two goals is with thorough analysis. This is key. A successful value investing operation must include thorough analysis (also known as doing your homework and digging into the details).
You want to manage your investment operation like a business: with discipline, a process you follow with defined rules and criteria.
Like we said in “Part 1: What is Value Investing,” investing is difficult. We can neither control nor predict the future. So, what can we do?
“We have no control over outcomes, but we can control the process. Of course, outcomes matter, but by focusing our attention on process, we maximize our chances of good outcomes.” – Michael Mauboussin
Process, Process, Process
We must focus on what we can control: our process. Call it what you want, an investment process, a decision-making process, a funnel, a procedure. Whatever label you choose, we need to define it.
There are four key areas to an investment process.
- Finding opportunities
- Value assessment / evaluation
- Risk management
An Example Value Process
Note: the investment process outlined here borrows heavily from Professor Bruce Greenwald at the Columbia Business School and Joel Greenblatt. I highly recommend reading their work.
1. Finding Opportunities
Remember the goal is to purchase securities when their market prices differ significantly from their fundamental value. It’s about comparing price versus value.
Value opportunities tend to have a higher value than their market price. They appear cheap or ugly. They tend to be obscure, ignored or difficult to understand (for example: special situations). In general, a good value opportunity requires more work than most investors are willing to give. I know that sounds crazy that investors wouldn’t want to spend time on their investment decisions. But, it’s a great thing for us value investors.
What if you find something that looks promising, but is outside of your circle of competence? Good question. When facing a promising new territory, we must explore, we must learn, we must… do our homework (or talk to someone we trust to help us).
We shall not cease from exploration
And the end of all our exploring
Will be to arrive where we started
And know the place for the first time.
– T.S. Eliot’s “Little Gidding”
The goal in this phase is to identify opportunities that seem worthwhile, at least enough to spend our precious time digging deeper. Although I’ve been picking stocks for 14+ years, I’m still developing my nose for smelling a promising opportunity. Every opportunity I dig into helps expand my circle of competence, even if it ends up a dud. Every now and then an opportunity sticks itself out, like it’s jumping up and down, and finding it makes me giddy with excitement.
2. Value Assessment
Once you’ve found an opportunity, it’s time to evaluate it. I recommend starting with the Balance Sheet, paying close attention to asset values and the capital structure. If something looks funky, go read the footnote. Remember, sometimes a scary capital structure can keep other investors away, which can be an advantage for us.
Next, I like to look at the statement of cash flows. Is the business earning cash? How is management spending the excess cash? Spend some time thinking about the industry, how it may be different than others, and where the business sits in that industry.
Then, I look at the income statement. Are revenues growing? Is the business profitable? Are costs going up, down? How are margins? How does this compare to the industry?
Finally, it’s time to evaluate the business’ earnings power. I’m hesitant to call this a “metric” as it’s more a quality (to me). It considers the business’ competitive position, addressable market, barriers to entry, management, financial condition–just about everything you can wrap your head around. The question to answer is: how will the business perform relative to its industry? I recommend answering with a range of possible outcomes.
Now you want to compare the value to the market price again. Did your initial price vs. value (phase 1) change? Is it better or worse? Are you looking at a bargain, something reasonably priced, or something expensive?
The topic of valuation is a big one and I’ll cover it in more depth in a future post.
The review phase is meant to focus on the key issues, your personal biases, the risk/reward and trade structuring.
- Key issues: Have you identified a dominant factor for the business or how the market is valuing the business? Maybe there are some nagging questions or concerns, spend some more time on them.
- Personal biases: Is a prior experience coloring your view on this business? Markets are a great teacher, but sometimes we learn the wrong lesson. (Example: Discarding whole industries because we lost money in that industry in the past.)
- Risk/reward: What are the possible outcomes you’ve identified? The worst case is the one where you can lose the most money, this is your risk. Are you comfortable with this outcome? Are you comfortable with how much you are paying for this risk?
- Trade structuring: Is there a way to structure the trade in a way to limit down-side risk while leaving the upside open? If so, does this structure limit the investment in any way (for example, options are time-bound)?
4. Risk Management
The risk management phase is our final check. The order doesn’t matter, but at least these three areas need to be covered.
Margin of Safety. Does the investment offer a satisfactory margin of safety? Is the market price well below our value assessment? I typically refer to the risk/reward from the “review” phase.
Diversification. Am I buying another social internet business when I already have 50% of my portfolio in the social internet businesses? The point of diversification is to invest in separate industries. Why? Every so often a huge exogenous factor will come around and shake up an industry. Making sure we’re not overly exposed to one industry lowers the impact to our portfolio.
Patience. Arguably the most important trait for a value investor is patience. Am I being a patient investor, am I chasing returns or am I being pressured into an investment decision? When envy and greed collide, they create an especially destructive force. Remembering to be patient can help you not chase other people’s ideas. But… if you do decide to follow someone else, at least have the patience to do your own thorough analysis first.
Your Own Process
The process outlined above is meant to be a general framework. Feel free to take from it what you want, tweak it, add to it, or scrap it altogether. The point is to find a process that works for you, leveraging your strengths and keeping your weaknesses in check.
- Thorough analysis is the way to safety of principle and satisfactory returns.
- We can’t control outcomes, but we can control our process, so focus on process.
- There are at least 4 steps to a value process: finding opportunities, value assessment, review and risk management.
- A value investor = a patient investor.
- Define a process that works for you.