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1 Approaches to Investing Long TermShort TermEfficient Market Fundamental (Value) Levels Mkt. Price vs. Value We Are Here Fundamental (Value) Technical.

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Presentation on theme: "1 Approaches to Investing Long TermShort TermEfficient Market Fundamental (Value) Levels Mkt. Price vs. Value We Are Here Fundamental (Value) Technical."— Presentation transcript:

1 1 Approaches to Investing Long TermShort TermEfficient 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 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 3 Real S&P 500 and Trend

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9 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 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: 20002010 Dividends 85%Value Value = current price (i.e. 110)  80x earnings.

11 11 Value Investing the Approach Value Review Manage Risk Search (Look systematically for undervaluation)

12 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 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% InflationHistorical Bonds: 5% vs. 3½ % at comparable inflation rates Notes: 4 ½ % vs. 2% Stock under valuation not so clear

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17 17 Systematic Biases 1. Institutional Herding – Minimize Deviations Window Dressing (January Effect) Blockbusters 2. Individual Loss Aversion Hindsight Bias Lotteries

18 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 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 20 Value Investing the Approach Value Review Manage Risk Search (Look systematically for undervaluation)

21 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 22 Valuation Approaches Net Present Value of Cash Flow Value =  CF t = CF 0 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 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 =CF o +CF 1 1 1 + R + … +CF 20 20 1 +... Good Information (Precise) Bad Information (Imprecise) = Bad/Imprecise Information Profit Margin Cost of Capital Growth Required Investment

24 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 25 Value Investing Basic Approach to Valuation “Know what you know”; Circle of competence 1. Organize valuation components by reliability Most ReliableLeast Reliable 2. Organize valuation components by underlying strategic assumption No Competitive Growing Competitive Advantage Advantage

26 26 Basic Elements of Value Strategic Dimension Growth in Franchise Only Franchise Value Current Competitive Advantage Free Entry No Competitive Advantage Asset ValueEarnings Power Value Total Value Tangible Balance Sheet Based No Extrapolation Current Earnings Extrapolation No Forecast Includes Growth Extrapolation Forecast Reliability Dimension

27 27 Industry Entry - Exit Remember, Exit is Slower than Entry. IndustryMarket Value Net Asset ValueEntry Chemicals$2B$1BYes (P  MV  ) (Allied)$1.5B$1BYes $1.0B$1BStop Automobiles$40B$25BYes (Sales  MV  ) (Ford)$30B$25BYes $25B$25BStop Internet$10B$0.010B?

28 28 Asset Value Assets CashBookBook Accounts ReceivableBookBook + Allowance InventoriesBookBook + LIFO PPE0Orig Cost  Adj Product Portfolio0Years R & D Customer Relationships0Year SGA Organization0 Licenses, Franchises0Private Mkt. Value Subsidiaries0Private Mkt. Value Liabilities A/P, AT, ALBookBook DebtBookFair Market Def Tax, ReservesBookDCF Bottom Line Net Net Wk CapNet Repro Value Reproduction Value Basic Graham- Dodd Value

29 29 Asset Value Approaches Remember, Low M/B is very hard to beat. Opportunities NoneLimitedMore Extended Value in Practice YesYesYes Industry Knowledge None NoneExtensive Stability/Reliability HighLowIntermediate Goodwill 0HistoricalReproduction Debt BookBookEst Market (Low Debt) (0 Enterprise)(0 Enterprise) ApproachGrahamBookReproduction

30 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 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 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 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 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 35 Earning Power and Entry - Exit Asset ValueEP Value Case B: Free Entry Industry Balance Case A: Asset ValueEP Value Value Lost to Poor Management and/or Industry Decline Asset ValueEP Value Case C: Consequence of Comp. Advantage and/or Superior Management “Sustainability” depends on Continuing Barriers- to-Entry

36 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 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 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 39 Summary of Basic Valuation Compute: Asset Value (Most reliable) EP Value (Second most reliable) Case A: Asset Value  EP ValueValue = EP Value (500M)(300M)+ Catalyst Value Case B: Asset Value = EP ValueValue = 500M(500M) Case C: Asset Value  EP ValueValue = Asset Value (500M)(1000M)+ Sustainable Fraction of Franchise Value (1000M-500M)

40 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 41 Basic Strategy Framework Porter Five Forces – Probability Determinants Four Forces too many Substitutes CustomerSuppliers Entrants Industry Competition

42 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 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 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 45 Barriers to Entry Incumbent Cost Advantage EntrantIncumbentSources 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 46 Barriers to Entry Incumbent Demand Advantage EntrantIncumbentSources 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 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 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 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 50 Other Barriers-to-Entry Government, Regulatory, Public (Lead based Gas Additives; Cigarettes) Informational (Who Knows What) (Banks, Financial Services, HMO’s)

51 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 52 Performing Strategic Analysis Apple Computer - Industry Map Industry: Identify SegmentsStep 1: For Apple Segment Are: Chips Hardware Software Step 2: Step 3: Chips Components Hardware SoftwareNetworks 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 53 Performing Strategic Analysis Do Barriers/Competitive Advantage Exist

54 54 Performing Strategic Analysis Nature of Barriers-to-Entry Competitive Advantage

55 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 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 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 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 59 Value of Growth - Basic Algebra

60 60 Valuing Growth Case 1: ROC  Return on Capital  Cost of Capital  R ThenROC – GR – GR – 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 – G10 - 0 R-G10 - 0 = = 1 G = 0% ROC – G10 - 2 R-G10 - 2 == 1G = 2% ROC – G10 - 8 R-G10 - 8 = = 1 G = 8% e.g. (ROC = R = 10%) =

61 61 Valuing Growth Case 2: Competitive disadvantage with growth ROC less than cost of capital then ROC – G < R - G  ROC – G < 1 R – G and ROC – G gets smaller with higher growth rates. R – G Higher Growth at a Competitive Disadvantage Destroys Value ROC – G8 - 0 R-G10 - 0 = =.8G = 0% ROC – G8 - 2 R-G10 - 2 ==.75G = 2% ROC – G8 - 8 R-G10 - 8 = = 0G = 8% e.g. (ROC = 8%, R=10%)

62 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 – G15 - 0 R-G10 - 0 = = 1.5 G = 0% ROC – G15 - 2 R-G10 - 2 = = 1.625 G = 2% ROC – G15 - 8 R-G10 - 8 = = 3.5G = 8% e.g. (ROC = 15%, R = 10%)

63 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 64 Valuing Growth - How much Does it Add?

65 65 Valuing Growth High (Unstable) Growth

66 66 Valuing Growth Breakeven Growth Rate

67 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 68 Summary of Valuation Value Review Manage Risk Search (Look systematically for undervaluation)

69 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 70 Summary of Valuation Asset Value EP Value Growt h Value MV < AV, EPV AV < MV < EPV AV, EPV < MV BUYAssess Comp. Adv. Lots of Luck BUY Sustainable? NoYes Most certain but mgt.? Medium certain Sustainable? Uncert ain

71 71 Summary of Valuation Strategic Dimension Growth in Franchise Only Franchise Value Current Competitive Advantage Free Entry No Competitive Advantage Asset ValueEarnings 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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