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The Value Spectrum - Where to be


Cunninghamew
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There are a lot of value investor types out there. I like to think of it is a spectrum.

 

1. At one end, you have the G&D types who focus on the most objective measures of value - like what are the assets of this company worth today

2. In the middle, you have people who care about the value of assets today + the earnings power of those assets

3. At the other end, you have people who focus more on the future earnings power of assets and a company's ability to grow/reinvest profitably (more GARPy in nature),

 

I am naturally wired to hang out at the start of that spectrum. I have never been good (or have even tried) to find high quality biz's trading at fair or slighlty discount valuations.

 

When I look at my portfolio today and see junky companies trading at say 20-25% discounts to fair value it makes me squeemish. I would much rather own a great asset with a good owner operator trading at, say a 10% discount. For the past few weeks, I have been trying to find good companies at decent prices (for the first time) and replacings some of my less discounted names with those. It has been hard.

 

Anyways... what am I getting at? I want to know if people tend to stick to one type of investment across all time horizons or do they alter their approach as the opportunity set changes? I.e. are you always a net net guy or are you a net net and GARP guy? Furthermore, does your style change as the enviroment changes?

 

To me it seems like it would make the most sense to use my style in the early years following a big bear market, but to gradually morph into a focus on quality later on. What got me thinking about this was someone's comment on TDG. They said, that TDG was on their list to buy in a bear market (or something like that). 

 

I really like TDG as a business, but would I ever buy it in a bear market or at that time would I be able to find juicier investments?  I too have a list of businesses I would love to own, but I never buy them. When this list goes on sell there is usually other stuff that seems more fun.

 

Hope those comments make sense. Thoughts?

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Makes sense.

 

My own preference is for quality. Financials, products, management, moats and everything else.

On top of that, I then try to deselect businesses that aren't in growth industries.

Also, if it's a small-cap and I think the moat is unusually robust then that's even better.

 

Mostly though (and not by any design), it turns out that mid-caps are where I think there are slightly more opportunities for my personal investment approach.

I also like to concentrate on my 5 to 10 top ideas and not invest any money in companies outside of those.

 

Each to their own though, I think I find greater efficiencies and get more of a kick out of what I do by sticking to what works for me.

My guess is that might well apply to others too.

 

 

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"Patience, Grasshopper." (Kung Fu) -I watched one company for over twenty years before it became cheap enough to buy.  Each year I would take annual report and write down the key ratios on an old fashioned spread sheet, then it suddenly was selling for about 1/2 book.  It is about 1/3 of my portfolio.  Later I found out the company was aggressively buying back its stock.

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I'm all over the lot, depending somewhat on where we are in the cycle.  I tend to go back and forth between micro caps and small caps and between deep discount to BV and moderate premiums.  The only stocks selling at deep discounts to TBV now are insurance stocks and most of those are reinsurers.  The largest cap stock recently has been OCN, about $5B.  I prefer to stay away from stocks with sell side analysts, but that seems to run in cycles as well.

 

I think you give up too many choices with just one set of parameters. 

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I agree.  Interestingly this was the topic I wrote about in my fund's most recent letter:

 

Why We Don’t Care (Much) About Book Value

 

By definition, a value investor is someone who seeks to purchase securities for less than what they are worth.  For many value investors that means focusing on the balance sheet and looking for companies where the market price is below the value of the firm’s net assets (i.e., discount to book value).  On the conservative end of the value spectrum are investors looking for “net-nets” where the market price of the stock is less that current assets minus all liabilities.  (For those who don’t readily recall what they learned in accounting, current assets include items such as cash, accounts receivable, and inventory.  In other words items expected to be converted into cash within one year.)  Essentially this means net-net investors place no value on plant and equipment and other items that are not listed on the balance sheet as current assets. This situation is very rare and typically there are just a handful of stocks to choose from.  What is helpful is that technology has made them easier to find due to screening programs.

 

Nearly all value investors broaden their approach beyond accounting book value and look for hidden assets, such as undervalued real estate, or items that have been depreciated whose true value is much greater than what it appears on the accounting statement.  This increases the potential pool of investment opportunities without significantly increasing downside risk; however, it requires more investigative work. A screening program cannot tell you if the real estate is undervalued on the books or if the true value of certain assets is greater than the accounting book value.  These first two approaches are not focused on the value of the ongoing business, rather they are focused on the value of the business’ assets.

 

Most value investors broaden even further to look for low price to book value stocks.  Ideally the market is pricing the stock below book value, but some will allow for a modest premium to book.  Typically these are situations where the investor’s downside is limited to the modest premium over book or liquidation value being paid, but the upside is greater since the company’s prospects for future earnings is higher than the net-net or liquidation value approach. 

 

While we continually look at and occasionally invest in all three of these types of situations, we long ago gravitated to an earnings focused style of value investing.  Warren Buffett described it as moving on from the “cigar butt” approach, where there is one good puff left, to focusing on higher quality businesses that are highly likely to continue to generate free cash in the future.  In other words, what we are striving to do is find securities where the market is mispricing the future stream of cash flows. 

 

We are looking for stocks with low price to earnings, typically below ten, that have modest, or better, earnings growth prospects.  If the price paid is low enough, and the growth does not materialize, our downside should be limited.  Hopefully, the downside is that the stock “only” generates returns equal to its earnings yield (the inverse of price to earnings).  For example, if we pay eight times earnings and earnings remain flat, the stock would hopefully generate a 12% annual return over time.  The only way this occurs in reality is if it is not a capital intensive business.  Then earnings are truly free cash flow and can be used to pay down debt, purchase income generating assets, pay dividends, or repurchase shares. 

 

Ideally, growth will materialize, resulting in market beating returns due to having earnings increase, and having the market multiple expand.  PE (price to earnings) multiple expansion is the essential component necessary for this approach to significantly outperform.  This is why the price paid is of great importance. For example, if we purchase a stock at eight times earnings, and earnings grow 25% over three years, and the market valuation increases from eight times earnings to a more rational thirteen times, we would double our money over that three year time frame, which equals 24% annualized returns before fees and expenses.  The sooner the PE multiple expansion occurs the greater the returns will typically be. 

 

What we do not do is follow the “growth approach” where current valuation is high in relation to the company’s current earnings.  In other words the buyer pays a high price to current earnings based on a very high projected growth rate (typically 20% or more per year).  Success requires the high growth to materialize and for the high price to earnings multiple to remain stable.  The downside (which we find unacceptably risky) is that if the growth stops (or slows) the stock price will typically crater due to it suddenly going from a high projected growth rate to a low projected growth rate.  In other words PE multiple contraction occurs, which can be devastating to returns.  This approach requires a great deal of investigation and accuracy in regards to future prospects and involves too much downside risk in our opinion.     

 

 

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I understand everyone has different style. But I'm also surprised how dogmatic value investors get on this topic. Live and let live.

I have holdings in three categories.

1) cheap assets (doesn't need current moat)

2) cheap earning, need some degree of moat

3) moat with growth that i'm not paying for.

All categories happily coexist. 

Lisa Rapuano of Five Lane Capital has a good discussion of this, but i can't find the video. Basically, how Mastercard and some education stocks sit side by side and balance each other. Oddball had a blog post about owning Mastercard and small, cheap asset plays.

Generally i lean towards quality in the businesses, but try not to pay for it.

 

 

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"Patience, Grasshopper." (Kung Fu) -I watched one company for over twenty years before it became cheap enough to buy.  Each year I would take annual report and write down the key ratios on an old fashioned spread sheet, then it suddenly was selling for about 1/2 book.  It is about 1/3 of my portfolio.  Later I found out the company was aggressively buying back its stock.

 

That's awesome! Congrats on finally being offered a great price to buy something worth following for 20 years.

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I understand everyone has different style. But I'm also surprised how dogmatic value investors get on this topic. Live and let live.

I have holdings in three categories.

1) cheap assets (doesn't need current moat)

2) cheap earning, need some degree of moat

3) moat with growth that i'm not paying for.

All categories happily coexist. 

Lisa Rapuano of Five Lane Capital has a good discussion of this, but i can't find the video. Basically, how Mastercard and some education stocks sit side by side and balance each other. Oddball had a blog post about owning Mastercard and small, cheap asset plays.

Generally i lean towards quality in the businesses, but try not to pay for it.

 

I really appreciate your dogmatic comment.  Sometimes value investors can be quite snobby about what the best method is.  Often, it's their method.  Seth Klarman was humble enough to claim that he never graduated to the "GARP" way of investing from cigar butts. 

 

Deng Xiao Ping Said "It doesn't matter whether a cat is white or black, as long as it catches mice."   

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I agree.  Interestingly this was the topic I wrote about in my fund's most recent letter:

 

Why We Don’t Care (Much) About Book Value

 

By definition, a value investor is someone who seeks to purchase securities for less than what they are worth.  For many value investors that means focusing on the balance sheet and looking for companies where the market price is below the value of the firm’s net assets (i.e., discount to book value).  On the conservative end of the value spectrum are investors looking for “net-nets” where the market price of the stock is less that current assets minus all liabilities.  (For those who don’t readily recall what they learned in accounting, current assets include items such as cash, accounts receivable, and inventory.  In other words items expected to be converted into cash within one year.)  Essentially this means net-net investors place no value on plant and equipment and other items that are not listed on the balance sheet as current assets. This situation is very rare and typically there are just a handful of stocks to choose from.  What is helpful is that technology has made them easier to find due to screening programs.

 

Nearly all value investors broaden their approach beyond accounting book value and look for hidden assets, such as undervalued real estate, or items that have been depreciated whose true value is much greater than what it appears on the accounting statement.  This increases the potential pool of investment opportunities without significantly increasing downside risk; however, it requires more investigative work. A screening program cannot tell you if the real estate is undervalued on the books or if the true value of certain assets is greater than the accounting book value.  These first two approaches are not focused on the value of the ongoing business, rather they are focused on the value of the business’ assets.

 

Most value investors broaden even further to look for low price to book value stocks.  Ideally the market is pricing the stock below book value, but some will allow for a modest premium to book.  Typically these are situations where the investor’s downside is limited to the modest premium over book or liquidation value being paid, but the upside is greater since the company’s prospects for future earnings is higher than the net-net or liquidation value approach. 

 

While we continually look at and occasionally invest in all three of these types of situations, we long ago gravitated to an earnings focused style of value investing.  Warren Buffett described it as moving on from the “cigar butt” approach, where there is one good puff left, to focusing on higher quality businesses that are highly likely to continue to generate free cash in the future.  In other words, what we are striving to do is find securities where the market is mispricing the future stream of cash flows. 

 

We are looking for stocks with low price to earnings, typically below ten, that have modest, or better, earnings growth prospects.  If the price paid is low enough, and the growth does not materialize, our downside should be limited.  Hopefully, the downside is that the stock “only” generates returns equal to its earnings yield (the inverse of price to earnings).  For example, if we pay eight times earnings and earnings remain flat, the stock would hopefully generate a 12% annual return over time.  The only way this occurs in reality is if it is not a capital intensive business.  Then earnings are truly free cash flow and can be used to pay down debt, purchase income generating assets, pay dividends, or repurchase shares. 

 

Ideally, growth will materialize, resulting in market beating returns due to having earnings increase, and having the market multiple expand.  PE (price to earnings) multiple expansion is the essential component necessary for this approach to significantly outperform.  This is why the price paid is of great importance. For example, if we purchase a stock at eight times earnings, and earnings grow 25% over three years, and the market valuation increases from eight times earnings to a more rational thirteen times, we would double our money over that three year time frame, which equals 24% annualized returns before fees and expenses.  The sooner the PE multiple expansion occurs the greater the returns will typically be. 

 

What we do not do is follow the “growth approach” where current valuation is high in relation to the company’s current earnings.  In other words the buyer pays a high price to current earnings based on a very high projected growth rate (typically 20% or more per year).  Success requires the high growth to materialize and for the high price to earnings multiple to remain stable.  The downside (which we find unacceptably risky) is that if the growth stops (or slows) the stock price will typically crater due to it suddenly going from a high projected growth rate to a low projected growth rate.  In other words PE multiple contraction occurs, which can be devastating to returns.  This approach requires a great deal of investigation and accuracy in regards to future prospects and involves too much downside risk in our opinion.   

 

Great Post.  Your clients are lucky to have such a thoughtful manager.  I too have gravitated towards similar approaches, screen for low ebit/ev, low debt, reasonable roe and substantial insider holdings/ buying, then look for qualitative factors. 

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I mainly use book value, probably  because I'm not smart enough for anything else. 

 

For these kinds of markets I think it pays to be able to see bargains that aren't as obvious, and also to have the conviction to be able to concentrate, since there aren't as many ideas.  If all you can see is the obvious bargains then you are sort of like a one pitch pitcher getting bumped up to the majors.

 

The one area I'd really like to become competent in is turnarounds and cyclical companies.  There are some ridiculous opportunities in these, especially in smaller companies, but you have to have the vision and judgment.  Mexican Restaurants was a good example of this.

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