There are two distinct approaches to value investing: Deep-Value & Wide-Moat. This post explores both.
Note: In his book Value Investing, Bruce Greenwald mentions a third approach: Earnings power-based (EPV). The line between EPV & Deep-Value is thin but interesting.
Deep-Value: Discount to intrinsic value as per liquidation or asset-values
Philosophy: Classic, old-school Ben Graham investing. Buffett started out with this. It involves buying a business for less than the value of its assets. Several blends exist:
- buying below liquidation value (by far the cheapest),
- buying below working capital aka net-nets or NCAV (closely related to the first),
- buying below tangible book value,
- buying a business with significantly understated book-value (often because PPE and/or Land as stated on the books are worth much more in reality). In modern forms, it involves buying companies for much less than they would be worth to a strategic buyer (generally buying at a discount to sales ‘asset’).
Deep-Value investing is about the business in its present form. This is a classic balance-sheet, asset-focused type of investing. The attention is exclusively on the balance sheet or perhaps top-line income statement if you’re looking at an activist target. It is crucial to peruse the income and cash flow statements to ensure you aren’t investing in a company going down in flames (a value trap). The value is obtained from the current business, not its future (think Danny Devito in Other People’s Money). You are only concerned with what is in the books – not with how the business is presently run or how it is responding to competitors. You want deep-value targets to be mediocre as this attracts activists and discourages management from pouring more capital into the business. Moreover, you want to shun growth. Growth demands reinvestments, and without a moat, a deep-value business often can’t invest profitably. Every dollar that the company invests in growth is a dollar that isn’t in your pocket. It’s a dollar that you can’t put into other (more profitable) assets. Think of what Buffett did with Berkshire Hathaway by taking all cash flows from the textile business and pouring them into See’s Candy. You are looking for moat-less companies.
Process: Traditional deep-value investors are more scientists than artists. They’re concerned with numbers over business strategy. They’re good at going into industries with negative macro trends, buying assets at a huge discount and waiting for the industry to recover. The best of them are experts at analyzing financial structures. They’ll dig through complex financial statements, separate the company into all of its subs and discover underpriced securities. They’ll read through the footnotes to find hidden values. Many will diversify, knowing that the odds are on their side if they buy a basket of 30 or so stocks at a big discount to asset value. This is exactly what Ben Graham preached and Walter Schloss perfected. It worked out well for both of them. Deep-Value investors with a flair for narratives maintain concentrated portfolios. They are good at identifying catalysts that would unlock value. Speaking of catalysts, Deep-Value investing tends to lend itself to activism, as activists are adept at identifying and unlocking hidden value. A consummate example is Seth Klarman.
More: Learn how companies overstate or understate numbers. Learn about financial shenanigans and shortcuts to identify them. Learn how to dig through the footnotes on off-balance sheet items. Think about the business in terms of its assets than earnings or cash flows. Consider the viewpoint of a strategic buyer instead of its current state of affairs. Read and follow the best activist letters and search through 13-D filings. Try to see what value the good activists see in the companies they work on. Read through merger proxies to see how companies think about buying each other to see if you can build ‘mental models’ for companies that trade at a discount to what a strategic buyer would look for. Keep in mind:
- Do not act until the bad news is widely known.
- Analyze the source of the problem and its seriousness.
- Identify a solution to the problem. Common solutions:
- hire new management.
- injection of new capital to passage of time
- Determine what the intrinsic value OR the price maybe once the problem is solved.
- Invest only if the gap is sufficiently large. Sample Rule: invest when you can achieve a double over a 3-year period. (or 26% CAGR).
Franchise or Wide-Moat. Growth of Intrinsic Value
Philosophy: This is classic Fisher/Munger style perfected by the latter-day Buffett. The buying of ‘a great business at a good price’ style. It’s about finding a company selling for a below normal but usually a normal market multiple with a wide moat and a long runway to grow profitably. These are compounding machines or a ‘compounding cow’ with great earnings dynamics, growth dynamics and reinvestment dynamics. You are looking for beautiful castles that are protected by one or more moats which are open for all to see and yet cannot be encroached or replicated. The best moats are those that are wide and keep widening. These are businesses with high ROIC & ROE ratios. They are free-cash generators as a result of earnings which far exceed their capex requirements. Businesses wherein ROIC significantly exceeds WACC plus an ability to maintain those ROIC rates while reinvesting earnings to scale up free cash flows.
“Metaphorically, these commercial ‘cows’ will live for centuries and give ever greater quantities of ‘milk’ to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).” – Warren Buffett
Moat or Franchise-based investing is about looking at the business’ cash flows and income statement. Investors judge company’s current and future earnings. They’re incredibly concerned about the company’s competitive position. Key questions include: Does the business have an economic-moat? How did it come about? How long has it been around? How deep is it? Is it wide and widening? Are their competitors doing anything to breach it? Profitable growth, not just growth, is the key here. A moaty company that grows using its franchise creates incredible value. Think of See’s Candy versus Coca Cola 20 years ago. Both had rock solid franchises, great brand names and wide moats. But Coca Cola’s growth potential far outweighed See Candies’.
Process: The best franchise investors (FiVIs) are more artists than scientists. They are concerned with strategic thinking and competitive positioning (read Competition Demystified). FiVIs become experts in one or two industries (CirCo) and spend their time researching companies within them. They are comfortable investing in business for years on end and trusting their analysis of the company’s strategy. Wide-Moat investors are comfortable with extreme concentration and sitting on cash for long periods. Identifying franchises isn’t easy. They are few. Finding them cheap is even harder. So you have to prepare and wait. When the fat pitch comes, you have to ‘pounce with vigor’, meaning you must have the conviction and the courage to bet big. A FiVI will often follow the same company for years before it gets cheap enough to invest in. Think Buffett’s recent investment in IBM. He was following it for years, has Bill Gates on his board to expand his knowledge in IT, etc.
With Deep-Value businesses, time is your enemy. These businesses can’t increase intrinsic value because they can’t grow profitably. The faster they hit your target, the better your returns will be. You want these businesses to return capital to you- the faster, the better. Plus remember that you bought all those assets at a discount, so a dividend payment is basically the company giving you an asset in the form of a dollar that you paid $0.50 for. The best thing that can happen to you is a liquidation the day after you invest, or the company immediately being bought out.
Valuations
With a Wide-Moat business, you’re investing based on Earnings and Owner’s Earnings in particular. You want to pay attention to “Normalized” Earnings. And look at ROIC, ROE, cost of capital (WACC) etc. Stuff found in its income and cash-flow statements. Beware though and you must look at the quality of the stuff.
Beware first instincts when looking at a ratio or its trend. Remember it has a numerator and a denominator driving it. So consider each and both at the same time.
Do absolute valuations. Then do relative valuations. You’ll almost never look at the business’ P/B or tangible book value except at buy time. For Deep-Value investments however, using earnings based ratios is dangerous. Buying a Deep-Value business trading at a low PE could be flawed and potentially deadly. It likely means competition is just around the corner and is about to cause a huge cut in those earnings. Or maybe it means the business is at a cyclical peak. Or it could be the market penalizing the business because the managers are focused on growing and doing it at unprofitable levels. You want to make sure you are buying solid, hard assets and getting them at a discount, or buying the business at a very low P/S to encourage strategic buyers and activists with an asset investment.
Husain Kothari
January 2013
KIP Capital blog 