The little book of value investing
- 1. THE LITTLE BOOK OF VALUE INVESTING Submitted to - Mr. Ankur Kulshreshtha Submitted by - Mihir Manchanda (20DM120)
- 2. About the Author Christopher H. Browne (1946 December 13, 2009) was a famous value investor and longtime director at the firm Tweedy, Browne. Browne was often known as one of the best value investors ever. He graduated from the University of Pennsylvania in 1969 with a B.A. in history. He started his career at the firm Tweedy, Browne, co-founded by his father Howard Browne and a favorite brokerage firm among prominent value investors like Benjamin Graham and Warren Buffett. His success as an investor and shareholder, who held business management accountable, was renowned. In 2006 Browne authored a book, The Little Book of Value Investing, in order to teach ordinary investors the principles used throughout his career.
- 4. CONTENTS
- 5. Buy stocks on sale - The basic concept of Value Investing is Buying a business for far less than it is worth. When prices drop, people buy more of the things they want and need, except in the stock market. Everyone seems to think that they should buy stocks that are rising and sell those that are falling. Investors feel disillusioned when the stocks they own or markets decline significantly. This prevents them from buying stocks when they go down as they get scared. The time to buy stocks is when they are ON SALE and not when they are high priced because everyone wants to own them. Growth investing - There is nothing wrong with owning great businesses that can grow at fast rates. The fault lies in the price that investors pay.
- 6. Two principles of value investing: What is a business worth(intrinsic value) Dont lose money (margin of Safety) Most investors move from extreme pessimism to jubilant optimism. Rational value investors sit back and wait for the market to offer stocks for less than they are worth and to buy the same stocks back for more than their worth. Whats a business worth?
- 7. As a company increases it net worth or intrinsic value overtime, the value of the shares will increase. If the price of the stock rises from less than intrinsic value to intrinsic value over time, you have a win/win. Avoid investing in companies that have a lot of debt relative to their net worth. Such companies are far riskier investments than companies with excess cash. Also, such companies cede a measure of control to their lenders. Diversification provides a margin of safety and insurance against downturn in a few stocks/industries. Don't Lose Money
- 8. (The lower the price, the higher the return) Buying Low P/E has worked over the years in all countries and all industries. Earnings yield= inverse of P/E Use it to compare to other investments. Buying cheap on past earnings for such stable cost is good. Low P/E works in good and bad markets- Wait longer in bear markets to see returns. Best part of Low P/E approach is that it forces you to buy stocks when cheap and while fear is high. BUY EARNINGS ON CHEAP.
- 9. When: Poor earnings, Poor Industry conditions. Buy below book value (BV) per share Examples: insurance, banks. Use global search approach to uncover stocks below BV. Sometimes stocks sell below cash balances.Buying stocks that sell cheaply when compared to asset values works. Low P/B stocks
- 10. Value in friendly countries International investing is easier with standardized international accounting (IFRS). Example of Roche which setup Contingent liabilities reserves in profitable years. Then, after reserve was reversed, they would add it directly to book value and not have to report as income.
- 11. Insider buying can help find companies whose fortunes could turn for the better Insiders could sell for various reasons and is not as useful, there is only one logical reason to buy as they think stock price is going up. Insider buying of stocks selling at low P/E or below asset value is even better Insider buying and activist investors can act as catalyst for stock appreciation. Buy when insiders buy
- 12. Falling prices can be a double edged sword Markets fall time and again because of political or economic announcements. Similarly, individual stocks and sectors often fall on weaker than expected earnings or unforeseen events. This is the time to be buying, but investors panic and go to cash. Risk is more often in the price you pay than the stock itself Prices of solid companies with strong balance sheets and earnings usually recover. Todays worst stocksbecome tomorrows best stocks
- 13. Seek value the modern way Grahams Net-nets method. Net Current Assets = Current Assets (cash + inventory + receivables) Total Liabilities NCAV = Net current assets / Shares outstanding Look at prices paid in mergers and acquisitions to find stocks that are selling at a significant discount to what they are worth to a knowledgeable buyer. Look at other companies in the same industry and compare P/E, P/S and P/B. When an acquisition happens, you can take the purchase price to calculate the P/S, P/E, EBIT, EV, EBITDA etc and keep them for future reference.
- 14. When a bargain is NOT a bargain? We have to determine why a companys shares are cheap and which ones have little chance of recovery. WHY DO STOCKS BECOME CHEAP Company has taken on too much debt Future is unknown. Company should own twice as much as it owes Cyclical stocks (automobiles, large appliances, steel and construction) Avoid overly leveraged companies. Increased competition- If facing strong competition from a more efficient competitor with lower costs, then move on to the next candidate. Avoid companies that are subject to technological obsolescence. Stay away from companies whose financial reports are overly complicated.
- 15. Avoid too much debt. Ability to pay short term obligations. Check long term liabilities versus assets over years. Computer shareholder equity or book value. Take both ST and LT debt/shareholder equity. Compare this number to other companies in the industry The less debt means greater margin of safety. Strong balance sheet shows ability to survive when the going gets tough. Calculate Current ratio, Debt to Equity ratio of different companies for sake of analysis and comparison Balance sheet checkup
- 16. Income statement checkup Compare revenues across the years to see growth See revenues from different divisions to spot problems or spot strength in core business. See COGS as a % of sales. Steady gross profit means steady business and the better it is. SGA, the lower this number as % of sales the better. EBIT or operating profit is used bythe author in valuation ( also Magic Formula ) CALCULATE BOTH EPS AND DILUTED EPS. USE EBIT TO DETERMINE EPS AND DILUTED EPS Revenues rising Expenses in line with revenues Consistency of profits Cyclical earnings Growing profits Lot of one time charges Shares outstanding: Are they growing,flat or falling?
- 17. Thorough examination of an investment candidate Does company have pricing power? What is the outlook for prices? Can the company sell more? Can company increase profits on existing sales? Can the company control expenses? If company raises sales, how much of it will fall to the bottom line? Can the company be as profitable as it used to be or at least as profitable as competitors? Does the company have one-time expenses that will not have to be paid in the future? Does the company have unprofitable operations that can be shut? How much can the company grow over the next five years? How will growth be achieved? What will the company do with the excess cash generated by the business? Dividends? New stores/ factories? Acquisitions/ Buy back of shares? What does the company expect its competitors to do? How does the company compare financially with other companies in the same business?What would the company be worth if it were sold?Does the company plan to buy back stock?
- 18. International accounting Globally comparable accounting standards promote transparency, accountability, and efficiency in financial markets around the world. This enables investors and other market participants to make informed economic decisions about investment opportunities and risks and improves capital allocation.
- 19. Currency issues, hedging When you invest in foreign stocks,another aspect to consider is the currency. Currency could fluctuate against your local currency. You could choose to hedge the currency so that your return is dependent on the underlying investment. Example: If you buy 1000 pounds worth of a company stock, you could SELL a currency forward contract for 1000 pounds.
- 20. How do you pick a money manager? Does the manager have an investment approach and can explain it to you or any layperson in plain English. Has he applied it consistently over time? How is his Track record? Min 5 years, Prefer 10 years. Whose record is it? Is it the manager who is presenting or his predecessor? Do they eat their own cooking? Does he own the investment management firm?
- 21. Why do people not follow value investing principles Temperament: Read Behavioral finance. Herd instinct. People feel confident when investing with the crowd. Reputational and career risk of being a contrarian. Periods of under performance when following value investing. These are boring investments often. People seek instant gratification. Value investors are like farmers. They plant seeds and wait for the crops to grow. Overconfidence is another flaw of investors. The investment world equates activity with intelligence. Good long term performance results from beating the market in bad times. Caution should not be seasonal. Maintaining a steady state of mind in good and bad times is the key to successful long term investing.
- 22. Stick to your guns Value investing requires more effort than brains and a lot of patience. Growth and value are joined at the hip. Difference is a question of price. Track acquisitions P/BV, EV/EBIT.Use this to screen companies that are selling in the stock market at asignificant discount to what an LBO group may pay. This is called theappraisal method which is 3rd approach along with P/E and P/B. Buying stocks for less than they are worth and selling them as they approach their true worth is at the heart of value investing. Buy below intrinsic value with amargin of safety, exercise patience. Patience is the hardest part of using the value approach.
- 23. To sum up, value investors look to buy stocks below their intrinsic value with a margin of safety, but it is easier said than done. Even when armed with our facts and research, we can still be swayed by our emotions and the markets. So if you ever need some words of advice whenever it feels like you're going against the tide, Browne writes:'Value investors are more like farmers. They plant seeds and wait for the crops to grow. If the corn is a little late in starting because of cold weather, they don't tear up the fields and plant something else. No, they just sit back and wait patiently for the corn to pop out of the ground, confident that it will eventually sprout.' Final Summary