Applied Value Investing Session 1 46o1l

Session 1

APPLIED VALUE INVESTING Session 1

Introduction to long-ter m oriented value investing

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Agenda • Introduction to the course

• Why invest in stocks for the long-term • Introduction to value investing • Foundations of long-term investing

• Developing an investment hypothesis • Breaking down a hypothesis into work streams • Seeking evidence to prove / disprove your hypothesis

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Welcome • Thank you for investing your time, and g up for a new course!

• This course hopes to be a step on your lifelong journey to become a good investor • You are likely to get the highest return on your investment in this course if you review the reading material ahead of a session, participate in discussions during the class, and attempt the (optional) homework – but of course you already knew that • Reminder: Have you done the ‘pre-work’ exercise and created a paper portfolio of ₹ 100,000, online at etportfolio.economictimes.indiatimes.com? • Occasionally, you will see a slide with the heading ‘Food for thought’ and this sign – please ponder over the questions raised on such slides as part of your preparation for the class, as we will discuss further in class Food for thought 3

Disclaimer – this is not the usual stuff in fine print, so please do read! • Please assume that I am interested / have a position in all the stocks discussed through the course • Please do not assume that a discussion on a stock is a recommendation to buy or sell it • Please do your own research before buying / selling any stock • All examples are only meant to illustrate concepts and help you learn • The course really contains no ‘secrets’ – I have mostly synthesized and built on the thoughts and ideas of hundreds of people who have taught me in class, in conversations and through their books • All copyrights and trademarks are acknowledged, and images drawn from searches on the Internet are the property of their respective owners

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We will look at investing in stocks through a particular lens • ‘Bottom-up’ – not driven by a view of the macro-economy

• ‘Value-oriented’ – seek to buy stocks at below their ‘intrinsic value’ • ‘Long-only’ – buy stocks that offer good value, do not buy stocks that do not offer good value

• Long / short funds also sell short stocks, but we will not discuss shorting during this course • ‘Active’ – picking stocks, rather than investing in an index fund / Exchange Traded Fund (‘ETF’) • ‘Long-term investing’ – at least a 2 year investment horizon • A practitioner’s perspective – will build on (and may occasionally depart from!) theory

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Welcome to part 1 of the course • In sessions 1 to 7, we will learn the building blocks of long-term investing • • • • •

Session 1: Introduction to long-term oriented value investing Session 2 and 3: Assessing business quality Session 4 and 5: Assessing management quality Session 6: Financial analysis and forecasting Session 7: Valuation

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Objectives of the course

Help build the technical and psychological toolkit to become long-term investors

Help develop sound investment judgement

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Let us now imagine that we are a few months in the future Congratulations! You have recently ed the (fictional) investment firm Long-Term Partners as an analyst. You are encouraged to present an investment idea to the team. How would you go about it? Note: A hat tip, and a thank you is due to Prof Sobhesh Agarwalla for framing the course in this manner

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Imagine that your helpful colleagues at Long-Term Partners have given you a framework that they use

Let us review what they look for while evaluating a company

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First, some background

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A quick snapshot of the company’s past and present

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Summary financials to get a sense of scale

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On to the industry section

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Some quick context about the industry

We will learn about ‘scuttlebutt’ in session 3

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We will learn to assess the structural attractiveness of an industry in session 2

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We will learn to empirically assess the attractiveness of an industry in session 2

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We will learn to assess the ‘winners’ and ‘losers’ in an industry in session 2

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And finally onto the company itself

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We will assess the quality of a company’s business in session 2 using its Return on Tangible Capital Employed, and the extent of stability of margins

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We will assess whether a company is likely to earn returns on capital above the cost of capital, in session 3

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Growth is a key driver of the value of a company, as we will see in session 3

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The extent of variability of earnings and cash flows over a business or commodity price cycle is an important factor in assessing the quality of a business, as we will see in session 3

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We will learn about integrity, the most important of the four dimensions on which to evaluate management, in session 4

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We will evaluate whether a management team has run a business well, in session 4

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We will assess if a management team has sensibly invested the cash generated by a business, in session 5

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We will assess if a management team is incentivized to deliver long-term returns for shareholders, in session 5

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We will evaluate the historical performance of a company by analyzing its financial statements, in session 6

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We will learn to build financial models and make financial forecasts, in session 6

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We will use multiple techniques to triangulate the value of a company, in session 7

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We will worry about what can go wrong throughout the course, but especially in sessions 2 to 5

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We will try to understand the market’s expectations implicit in the stock price, in session 7. This will force us to assess if our expectations are already ‘in the stock price’

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We will learn about catalysts later in session 1

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We will learn about the psychological biases and institutional issues that hamper longterm investment performance (and how using a ‘devil’s advocate’ perspective is one way to overcome some of these handicaps) in session 11 34

Actively considering the opposing case and the possibility that our decision may be wrong forces us to ‘think thrice’ and makes our decisions more robust, as we will see in session 6 (on forecasting) and session 11 35

End with your ‘buy’ or ‘sell’ recommendation!

Consider this course as a kind of training for your fictional job at Long-Term Partners! 36

All that said, becoming a good investor can take a lifetime!

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The primary objective of investing is to consumption in the future

Saving

Investment

Withdraw saving

• During working years, set aside a portion of salary or other income for the future

• Invest savings in real assets (like a home) and financial assets (like stocks, bonds, fixed deposits)

• Draw down on the accumulated savings later in life, when there is often no salary • The returns on investments should be sufficient to for inflationary increases in cost of living

Investing can go beyond being saving for consumption in the future, to become an important source of wealth creation

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Investing in stocks can deliver good returns: the very long-term experience of the US Note that these are real returns (net of inflation)

Source: From ‘Stocks for the long run’ by Prof Jeremy Siegel, via http://viniyogindia.com/public/stocks-for-the-long-run-an-indian-perspective/

Small changes in the rate of return can lead to very large differences in value when compounded over long periods – bonds earn 6.3x the returns from bills, though bonds earn only 0.9 percentage points per year more than bills 40

Investing in stocks can deliver good returns: our relatively short experience in India Note that these are nominal returns (NOT net of inflation) ittedly, ~40 years is still a relatively short period, compared to 200+ years of data we have from the US As every mutual fund ad tells you, past performance is not an indicator of future returns Source: http://viniyogindia.com/public/stocks-for-the-long-run-an-indian-perspective/

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While long-term charts of the index look like smooth upward-sloping lines… S&P 500 index, monthly, 1950 to 2017

BSE Sensex, monthly, 1980 to 2017

Source: finance.yahoo.com, bseindia.com

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… they do include periods of stomach-churning losses Period

Change in S&P 500

Period

Change in Sensex

8/2000 to 9/2002

-46%

12/2007 to 2/2009

-56%

12/1972 to 9/1974

-46%

3/1992 to 4/1993

-50%

10/2007 to 11/2008

-42%

2/2000 to 9/2001

-48%

11/1968 to 6/1970

-33%

7/1997 to 11/1998

-35%

8/1987 to 11/1987

-30%

8/1994 to 4/1995

-32%

11/1980 to 7/1982

-24%

12/2010 to 12/2011

-25%

12/1961 to 6/1962

-24%

4/1996 to 11/1996

-25%

What would you do after a 50% loss? Source: Data from finance.yahoo.com and www.bseindia.com

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Most institutional investors appear to have a < 2 year investment horizon

Source: https://www.mfs.com/content/en_us/mfs-insights/lengthening-the-investment-time-horizon.html

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But holding periods vary from a few micro-seconds to decades (!) Microseconds

Hours

1-2 years

Decades

High Frequency Traders buy / sell in micro-seconds Day traders buy and sell (many times) during a day

Most institutional fund managers are in this range Investors like Warren Buffett and Charlie Munger, who hold for decades, are rare 45

Over time, average holding periods have shortened

Source: https://www.mfs.com/content/en_us/mfs-insights/lengthening-the-investment-time-horizon.html

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Having a long-term horizon offers opportunities for stock pickers At very short horizons, most stocks earn similar returns

At longer horizons, ‘winners’ and ‘losers’ are separated more clearly

While it is hard to beat a market index (especially net of fees), investors can develop the skills required to outperform the index Source: https://www.mfs.com/content/en_us/mfs-insights/lengthening-the-investment-time-horizon.html

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Most importantly, having a long horizon improves the odds… 1 year return on Sensex, 1980 to 2017

Rolling 5 year compounded annual return on Sensex, 1985 to 2017



Source: Data from bseindia.com

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… of realizing attractive returns from investing in stocks Period

Mean

Standard deviation

1 month

% of time compounded annual returns < 0%

% of time compounded annual returns over 10%

43%

1 year rolling returns

20.9%

36.6%

29%

57%

5 year rolling annual returns

16.5%

13.1%

8%

64%


16.1%

7.9%

1%

78%


14.9%

4%

0%

93%

Source: Data from bseindia.com

Compounded annual returns are nearly always positive for 10+ year horizons The probability of annual returns from stocks beating the average ~10% returns from fixed deposits in India increases as the horizon lengthens 49

In practice, it can be hard to invest for the long term Limited availability of long-duration capital

“Asset liability mismatch”

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Most clients (whose capital is managed by investment managers) have a relatively short horizon, and are hence unwilling to ‘lock up’ their capital for long periods with an investment manager

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Most of the capital that investment managers receive from their clients can be redeemed by their clients with a few days / weeks notice As a result, if investment managers invest for the long-term, there is usually a significant mismatch between the duration of their ‘assets’ (investments made with a long-term view) and their ‘liabilities’ (capital from clients that can be redeemed at relatively short notice) This mismatch could lead to an inability to truly invest for the long-term, as well as redemptions by clients (and hence forced selling by the investment manager) during a period when stock prices fall

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We will revisit these issues in session 11 50

All that said, there are many ways to invest successfully Finding the investment style that resonates with you intellectually and psychologically is an intensely personal journey, and can take a long time

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For the rest of this course, we will focus on building the toolkit to become long-term oriented value investors

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What is value investing? • Our working definition: Value investing is an approach to buying stocks for less than their ‘intrinsic value’ • It may be easier to first explain what value investing is NOT • “Company X’s stock has risen 2% every day for the last 3 days, so I will buy X today” • “Company Y is loss making and trades at 100x revenues, while a comparable company is growing slower and trades at 130x revenues, so I will buy Y today” • “Company Z should report good results tomorrow and the stock may rise, so I will buy Z today” • A value investor might instead say something like “Company V is currently trading at ₹ 100 per share, while I think ‘intrinsic value’ is ₹ 180-200 per share. So I will buy company V stock today”

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Another perspective, from a great investor • “Value investing is at its core the marriage of a contrarian streak and a calculator” - Seth Klarman, Baupost Group

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What does it mean to be a contrarian calculator? •

‘Contrarian’ implies that a value investor should be willing to take an opposing view to the ‘herd’ mentality often found in the stock market, as stocks that are unpopular among other investors are more likely to offer bargains

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The ‘calculator’ refers to the investor’s ability to reasonably assess the ‘intrinsic value’ of a company

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In most situations, the ‘intrinsic value’ of a company can be assessed relatively easily But there are exceptions – for instance, consider the case of a small biotech company which is working on an early-stage pipeline of promising products, The company has no revenues, and the success or failure of this pipeline may become clearer in 4-6 years. The range of outcomes on the ‘intrinsic value’ of the stock are even wider than the range of outcomes on the drug pipeline – the company may go bankrupt or be worth a few billion dollars! 56

Benjamin Graham is the father of value investing • Born in 1894, Benjamin Graham graduated from Columbia University in 1914 • Weeks before graduation, he received offers for teaching positions from three different departments at Columbia – Greek and Latin philosophy, English and mathematics – but he went to work on Wall Street and ultimately co-founded an investment firm called the Graham-Newman Partnership • Graham taught investing at Columbia Business School from 1928 to 1955 • Graham’s books laid the foundation for value investing • In 1934, Graham co-authored ‘Security Analysis’ with Columbia professor David L. Dodd • In 1949, Graham authored ‘The Intelligent Investor’

Source: http://c250.columbia.edu/c250_celebrates/your_columbians/benjamin_graham.html

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The three foundational concepts of value investing were detailed in Ben Graham’s books

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Stocks represent part-ownership of a business (so try to understand and value the business before buying the stock)

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Mr. Market

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Margin of safety

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Part-ownership of a business (1 of 2)

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Equity shareholders are the ultimate owners of a company and the residual claimant to company’s cash flows (after all claims from debt and other providers of capital have been settled)

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So the value of equity shares is inextricably linked to: • •

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The future cash flows generated by the business, and The quantum of debt and other claims to these cash flows (including instruments such as stock options and securities convertible into equity) “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – Benjamin Graham •

While stock prices in the short-term can, akin to a popularity contest, be affected by investor sentiment and other factors (the “voting machine”), over the long run, the stock market usually appropriately reflects the underlying ‘intrinsic value’ of the business (the “weighing machine”)

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Part-ownership of a business (2 of 2)

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Figuring out what the Mona Lisa is worth is a really hard

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Assessing the ‘intrinsic value’ of companies is easier, and we can relylouvre.fr on a few techniques (which we will learn more about in session 7), including • • • •

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Method A: Realizable value of assets, net of liabilities Method B: Discounted present value of future cash flows Method C: Valuation multiples of comparable companies Method D: Prior trading ranges of the company and / or its peers, especially if it is large, widely-researched and publicly traded for many years Always try to triangulate value using many of the methods above In shorthand, we refer to this triangulated valuation of the company on a stand-alone basis as the ‘intrinsic value’ of a company •

We will explore how the value of a company when it is acquired (called the ‘private market value’) will likely be higher than the value on the same company on a stand-alone basis, in session 7

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2

Mr. Market (1 of 3)

• Imagine you have a partner called Mr. Market in your business. The company is not publicly traded, and there are no other partners • Mr. Market is quite a character – he swings between extreme optimism (when he offers to buy out your share of the business, worth, say ₹ 100, at ₹ 200) and extreme pessimism (when he offers to sell you his share of the business, worth say, ₹ 100, at only ₹ 50) • The key thing to : You are not obliged to act, and can ignore Mr. Market (Mr. Market does not mind!) • Much like Mr. Market, the stock market periodically offers opportunities to buy into businesses at bargain-basement prices, or to sell shares at irrationally-exuberant prices

• Like with Mr. Market, there is no penalty for not trading on the stock market

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2

Mr. Market (2 of 3)

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2

Mr. Market (3 of 3)

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Ted Williams was one of the greatest batters in the history of baseball, and the author of a book ‘The science of hitting’

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In the book, Williams broke the ‘strike zone’ (the area where the ball was usually pitched) into 77 squares, each the size of a baseball, and assessed the probability of hitting the ball well in each of these squares

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According to Williams, “A good hitter can hit a pitch that is over the plate three times better than a great hitter with a questionable ball in a tough spot”

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According to investor Warren Buffett (who we will hear from a lot during the course!), “The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, 'Swing, you bum!,' ignore them” Source: https://www.fs.blog/2013/07/make-better-decisions/

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Margin of safety (1 of 4)

• Margin of safety is the extent to which the current stock price (due to the whims of Mr. Market!) is lower than ‘intrinsic value’ (which is assessed based on the value of part ownership of the business) • Margin of safety thus integrates the first two foundational concepts of value investing

• Margin of safety is usually expressed as a percentage of the ‘intrinsic value’ • If a stock is trading at ₹ 90 and ‘intrinsic value’ is estimated to be ₹ 100, the margin of safety is 10% [(100-90)/100] • An investor might say that he wants to buy the above stock with a 30% margin of safety, implying that he would buy at ₹ 70

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Source: www.valuewalk.com

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• Why buy with a ‘margin of safety’ • ‘Intrinsic value’ can be hard to assess • Things often do not go to plan – consumer tastes evolve, competitive intensity increases, top management leaves… • Valuing a business often involves having a view on the future, and most forecasting is really hard - more on this in session 6 • We are human, and (systematically) make lots of mistakes - more on this in session 11

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Buying with a large margin of safety can be a significant driver of investment returns. Here is a simple example •

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Suppose the intrinsic value of company X is ₹ 100 per share and the current price per share is say ₹ 60, implying a 40% margin of safety Assume that the stock pays no dividends Suppose intrinsic value is expected to grow at 15% per year. This implies that the intrinsic value of the stock will be worth ~ ₹ 150 in 3 years Assume that the stock will trade at intrinsic value of ~ ₹ 150 per share in 3 years So, your returns from investing in the stock today = {[(150 / 60) ^ (1/3)] – 1} which is ~36% per year 36% returns are much higher than the 15% annual growth in intrinsic value, due to buying the stock with a large margin of safety 67

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A short history of value investing: Benjamin Graham (1 of 2) • Benjamin Graham emphasized the importance of buying stocks at a discount to net realizable value of assets on the balance sheet • As you might expect, companies that are trading at large discounts to the realizable value of assets are usually not very good businesses and / or are going through very difficult times • Graham’s approach focused on the ‘here and now’ of a company’s net assets, and did not care much about the business or its future prospects • Graham recommended holding a widely diversified portfolio of such companies

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A short history of value investing: Benjamin Graham (2 of 2) • Benjamin Graham sought out ‘net nets’, which are stocks where the realizable value of assets (net of debt) was less than the value of the company • In July 2018, Applied Genetic Technologies (‘AGTC’), a biotech company that is in the process of developing genetic therapies for rare diseases, had a market value of $74mm, and net cash and investments of $112mm as of March 2018. For the quarter ended March 2018, AGTC had operating and net losses as well as cash outflows from operating activities of ~$8mm • AGTC is a ‘net net’ as the market value of the company is only 2/3 of the net cash on hand • This approach can be applied to situations where a company has realizable fixed assets (such as surplus real estate) or other assets such as investments that are collectively (net of debt) worth more than the market value of the company

Source: https://finance.yahoo.com/quote/AGTC/key-statistics?p=AGTC

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A short history of value investing: buy ‘cheap stocks’ (1 of 3) • Benjamin Graham’s insight can also be extended to situations where a stock screens as cheap on valuation multiples such as Price / Earnings, Price / Book, Enterprise Value (‘EV’) / Sales, EV / EBITDA, EV / EBIT and EV / Free Cash Flow – we will call this approach ‘quantitative value’

• Portfolios which use a ‘quantitative value’ approach usually have 3050 stocks, and are rebalanced periodically • Academic researchers found that the Capital Asset Pricing Model (‘CAPM’) was not able to fully explain the returns on stocks, and that stocks that screened as ‘cheap’ on valuation metrics delivered ‘excess returns’ (i.e., delivered returns in excess of what CAPM would predict)

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A short history of value investing: buy ‘cheap stocks’ (2 of 3) •

So Prof Eugene Fama and Prof Ken French created a ‘value’ factor which they called HML – stocks are sorted based on book / market value, and the stocks with the highest book / market value are designated ‘value’ stocks •

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HML, which is short for High Minus Low, is the excess return by going long the stocks that have the highest book / market value (the cheapest stocks, by this metric) and shorting the stocks with the lowest book / market value (the most expensive stocks, by this metric) • The Fama / French data library is at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_libra ry.html Fama-French factors for the Indian market have been computed by Prof Sobhesh Agarwalla, Prof Joshy Jacob and Prof Jayanth Varma •

The Indian Fama-French factors are at http://faculty.iima.ac.in/~iffm/Indian-Fama-French-Momentum/

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A short history of value investing: buy ‘cheap stocks’ (3 of 3)

Periods where the Fama-French value factor underperforms the S&P 500 Buying ‘cheap stocks’ does outperform on average, but it shows extended periods of underperformance 74

Philip Fisher had a very different approach to Benjamin Graham •

Philip Fisher was an investment manager who started his own investment firm Fisher & Co in 1931

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Fisher’s approach was to own high-quality stocks for the long run, and he famously owned Motorola from 1955 till his death in 2004

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Fisher’s book ‘Common Stocks, Uncommon Profits’ was the first investment book to make it to the New York Times bestseller list

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Fisher emphasized the importance of investing in companies with strong R&D and sales capabilities, run by high-quality management teams, and operating in large and growing end markets

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Fisher thus looked primarily at the long-term outlook for a company, and actively sought out good companies and ignored poor businesses. •

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In contrast, Graham mostly sought to find companies that were trading so cheap that their current market value was less than the realizable value of their assets, without thinking much about the long-term outlook for these companies Fisher also popularized the concept of ‘scuttlebutt’, which we will look at in session 3 Source: www.forbes.com/free_forbes/2004/0426/142.html

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Warren Buffett and Charlie Munger independently had exceptional investment track records in the 1950s and 1960s (1 of 2) • Warren Buffett was a student of Benjamin Graham at Columbia Business School, and worked from 1954 to 1956 at the GrahamNewman Partnership • From 1956 to 1969, Buffett managed the Buffett Partnership, mainly using a Graham-like value investing approach • The Buffett Partnership delivered unbelievable results – 30%+ annual returns that beat the index by 20+ percentage points with less volatility than the index, all without a single down year!

Source: The Warren Buffett portfolio by Robert G. Hagstrom

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Warren Buffett and Charlie Munger independently had exceptional investment track records in the 1950s and 1960s (2 of 2) • Buffet’s friend (and future partner) Charlie Munger was a lawyer, and Buffett convinced Munger to take up investing • Munger ran an investment partnership from 1962 to 1975, holding a more concentrated (and more volatile) portfolio than Buffett, but still delivered outstanding longterm results

• According to Buffett, “The blueprint he (Munger) gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices” Source: The Warren Buffett portfolio by Robert G. Hagstrom

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Charlie Munger encouraged Warren Buffett to combine Graham and Fisher’s approaches when they became partners in Berkshire Hathaway •

Warren Buffett and Charlie Munger partnered to set up Berkshire Hathaway. In 1972, Berkshire Hathaway acquired See’s Candies for $25mm - the seller wanted $30mm and Munger thought it was worth as much, but Buffett bid $25mm but “wasn’t all that enthusiastic even at that figure”

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Ultimately, the seller agreed to sell at $25mm, which was ~13x earnings

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Buffett says Munger convinced him to pay up for See’s, a good business that earned 50% return on capital – though the multiples were much higher than what Buffett had paid for businesses in the past (“A price that was 3 times net tangible assets made me gulp”)

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Buffett also credits Munger’s insight into the importance of the quality of the business for Berkshire Hathaway’s subsequent investment in many high-quality businesses like The Coca Cola Company • •

“If we hadn’t brought See’s, we wouldn’t have bought Coke” “Through watching See’s in action, I gained a business education about the value of powerful brands that opened my eyes to many other profitable investments”

Source: https://25iq.com/2016/11/25/a-dozen-things-warren-buffett-and-charlie-munger-learned-from-sees-candies/ http://www.berkshirehathaway.com/letters/2014ltr.pdf 78

Buffett and Munger thus took value investing into unexplored territory

Buy good businesses for the long-term, per Fisher

Buy at reasonable prices, per Graham

Buy good businesses at reasonable prices, and hold for the long-term

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Other investors have extended value investing into newer areas All these books are must-reads Howard Marks

High-yield and convertible debt

Seth Klarman

Distressed debt, bankruptcy and restructuring

Joel Greenblatt

Spinoffs, postbankruptcy stocks, ‘magic formula’ investing 80

Does value investing work? We need to look at the two broad schools of value ‘Cheap stocks’

Good business at reasonable prices

• There is good evidence that buying ‘cheap stocks’ works on average • Note that ‘value’ in this case is defined relatively easily (as the cheapest segment of the market, based on a number of valuation multiples) • Many value investors today try to invest in high quality businesses at reasonable prices - let us call this approach ‘QARP’ for Quality at Reasonable Price • In evaluating QARP, it is obviously harder to quantitatively measure what is a high-quality business, as well as what is a reasonable price • Can we prove that QARP works, beyond anecdotes about Berkshire Hathaway and some well-known investors? We will look at the evidence 81

Buying ‘cheap stocks’ clearly works – a closer look at HML for US stocks ‘Cheap stocks’

HML annual returns (%), 1927 to 2016 40 30 20 10

-10 -20

1927 1931 1935 1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015

0

-30 -40 -50

   

Average HML return 4.2%, Standard deviation 14.2%, Sharpe ratio 0.3 HML is positive in 55 of 90 years, but of course is negative in 35! Note the large underperformance in 1934,1938, 1939, 1980, 1991, 1999, 2007 Also see extended underperformance in 1937-1940, 1989-1991, 1998-1999, 2013-2015

Source: Data for Fama-French factor HML from http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/ftp/F-F_Benchmark_Factors_Annual.zip

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Buying ‘cheap stocks’, using P/E, EV/EBITDA and P/Book works in the US ‘Cheap stocks’ EV/EBITDA

All the value portfolios beat the S&P500, with better Sharpe and Sortino ratios

This is a good book for anyone interested in quantitative approaches to value investing Source: Quantitative value by Wesley R. Gray and Tobias E. Carlisle

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Buying ‘cheap stocks’ works outside the US, with multiple measures of ‘cheapness’ ‘Cheap stocks’

https://www.aaii.com/journal/article/why-value-beats-growth-a-brief-explanation.touch

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Buying ‘cheap stocks’ thus has conclusive evidence in its favour ‘Cheap stocks’

But what about QARP?

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One approach to ‘buy good business at reasonable prices’ is Magic Formula Investing QARP

• Joel Greenblatt quantitatively marries the 2 key aspects of the ‘Buffett / Munger’ approach – good business and reasonable prices, in a way that he calls ‘Magic Formula Investing’ • Greenblatt uses return on capital to assess if a business is ‘good’ and EBIT / Enterprise Value measures ‘reasonable price’ • Greenblatt ranks stocks on both these dimensions, added the two ranks together, re-ranked stocks based on the sum of the two ranks, and annually builds an equal-weighted portfolio of the 30 best stocks in this way

Source: The little book that beats the market by Joel Greenblatt

The ‘magic formula’ approach outperformed the index from 1988 to 2004, even if limited to the largest, most liquid stocks 86

Gray and Carlisle applied the ‘Magic Formula’ for 19642011 in their book ‘Quantitative Value’, with similar results QARP

The Magic Formula (‘MF’) portfolio significantly outperforms the S&P 500, delivering higher returns as well as Sharpe and Sortino ratios, with lower drawdowns

Source: Quantitative value by Wesley R. Gray and Tobias E. Carlisle

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But there are some practical issues that pure valuation screens may miss QARP

Unreliable financial statements

Financial distress

• The implicit assumption while using valuation metrics linked to the financial statements of a company, is that these statements are reliable • However, many companies actively ‘manage’ earnings to deliver ‘smooth’ results that meet analyst expectations • In addition, many companies are outright frauds

• A company that has a high risk of bankruptcy is at risk of permanently impairing the value of the company’s shares


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Gray and Carlisle create a quantitative process that is similar to what QARP investors use QARP

Clean the universe

Find the cheapest stocks

Find the highest quality stocks

• Remove stocks that have risk of being potential frauds and earnings manipulators • Remove stocks with a high risk of financial distress

• Find the cheapest stocks by ranking stocks based on EBIT / Enterprise value

• Identify stocks that are strong businesses, reflected in metrics such as those with high return on assets and stable margins, in addition to financial strength (relatively low leverage and high free cash generation)


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The quantitative replication of a QARP process delivers strong results QARP Gray/ Carlisle Magic Formula

The Gray/ Carlisle portfolio significantly outperforms the Magic Formula as well as the S&P 500, delivering higher returns as well as Sharpe and Sortino ratios, with lower drawdowns But the Gray / Carlisle strategy is but one way to implement QARP Source: Quantitative value by Wesley R. Gray and Tobias E. Carlisle

90

The plural of anecdote is not data QARP

• Berkshire Hathaway’s exceptional success has inspired a generation of investors to follow in the footsteps of Warren Buffett and Charlie Munger with QARP

• There are many mutual funds and hedge funds that follow QARP, with a long track record of outstanding performance • That said, there really is no data to objectively assess how the entire universe of investment managers applying a ‘buy good businesses at reasonable prices’ have fared 91

So, in summary, does value investing work? ‘Cheap stocks’

Good business at reasonable prices

This course will primarily use a QARP approach

• Buying ‘cheap stocks’ conclusively outperform the index, both on a raw and risk-adjusted basis • The Magic Formula and Gray / Carlisle methods of quantitatively testing a process conceptually similar to the process followed by QARP investors, deliver robust results for both raw and risk-adjusted returns • However, there are other approaches to QARP that are used in practice by investors, which have not been considered • In addition, these tests do not go back prior to 1960s or extend to non-US geographies, unlike tests for ‘buy cheap stocks’ • It is probably fair to conclude: the hypothesis that QARP delivers good returns has NOT BEEN NEGATED so far, though more evidence may be required to conclusively accept this hypothesis 92

93

But why does value investing work? Reward for risk?

Psychological biases

Institutional issues

• ‘Cheap stocks’ deliver higher raw and risk-adjusted returns • While the introduction of the HML factor is a way to explain stock returns beyond CAPM, it is unclear even to academics as to what ‘risk’ is really being priced in

• Value investing is psychologically hard to do - a number of deep-seated biases lead investors to over-react to bad news and makes them ‘loss averse’. As a result, it is difficult to buy stocks that have performed poorly in the recent past (and which are now trading at attractive prices)

• Value can under-perform for extended periods, while the clients of an investment manager may measure performance over shorter horizons • As a result, investors who care about protecting assets under management (and the related fees, as well as their jobs) may give up on ‘value’ when it is not working

We will dive into the psychological biases and institutional issues in session 11, as these appear to be the reasons why value investing works! 94

A short detour: understanding the role of a catalyst (1 of 2) •

A catalyst is an industry-wide or company-specific trigger that is expected to close the gap between current stock price and ‘intrinsic value’ •

•

•

New products, better-than-expected financial performance, settlement of a long-standing dispute are all examples Corporate actions like buybacks, spinoffs or the company getting acquired are generally hard to predict, but can also have a significant impact Additional disclosure of segment information in a company with multiple businesses can help investors better assess and value the company

95

A short detour: understanding the role of a catalyst (2 of 2) •

Many investors seek ‘value with a catalyst’

• A near-term catalyst reduces the risk of being stuck in a ‘value trap’, when a stock persistently remains cheap, and the market price does not converge with (your estimate of) ‘intrinsic value’ • A near-term catalyst can be particularly valuable in a poor or declining business • Other investors believe that ‘value is its own catalyst’ • Low expectations implied by the stock price may be exceeded as the business performance ‘mean reverts’ • Takeover offers from strategic or financial investors, or interest from activist investors (more on them in session 5) may become possible • But activism / M&A are unlikely where there are controlling shareholders 96




97

A simplified view of the corporate investment and growth cycle

Value of firm

Value of assets in place (‘AIP’)

Present Value of Growth Opportunities (‘PVGO’)

Investments increase the future value of AIP Assets generate cash

Return to providers of debt / equity

Investments may increase PVGO

Retain and invest cash for future growth

98

The contribution of AIP and PVGO in the ‘intrinsic value’ of a business can vary widely Indicative illustration of the share of AIP and PVGO in ‘intrinsic value’ 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

30% 70% 100%

100% 70% 30%

Benjamin Graham style 'net net'

Slow growing Acyclical Lossmaking but cyclical steadily growing fast growing business business tech startup

Assets in place

PVGO

99

Investment horizon

As the investment horizon lengthens and the share of PVGO in ‘intrinsic value’ rises, it becomes more important to understand the business and management

When AIP as % of ‘intrinsic value’ is very high, there are few growth opportunities and the business is Longless likely to grow in value over term time. So there is less reason to hold such a business long-term

Shortterm

The focus here is on valuing AIP, not PVGO

Understanding the business and evaluating management matters the most here!

Low

High PVGO as % of ‘intrinsic value’ 100

101

An introduction to the ‘investment process’ • The ‘investment process’ refers to the series of steps taken by an investor before deciding to (or not to) make an investment • With experience, investors refine and customize their investment process to identify good investments and avoid ‘unforced errors’ • Thus, the investment process adopted by an investor tends to reflect the lessons learned from prior investing experience • A novice investor’s investment process, which may rely primarily on tips from friends and brokers, is less sophisticated than a more skilled investor • In this way, the degree of sophistication of the investment process usually reflects the investor’s level of skill

102

A sound investment process for a long-term investor… • Traders who buy and sell a stock intra-day are focused primarily on factors such as news flow, market sentiment and stock price movements, as intra-day stock price moves have relatively little to do with the long-term fundamentals of the business • On the other hand, investment outcomes of long-term investors are primarily affected by the long-term fundamentals of the business • Understanding the quality of the business and management, and analyzing financial statements, is therefore an integral part of any long-term investor’s investment process • That said, the actual level of diligence conducted by a set of long-term investors can vary widely

103

… emphasizes detailed work on the business, management and financials Lessons from business diligence and financial analysis lead to updated hypothesis and conclusions

Hypothesis

Learnings from financial analysis feed into business diligence

Financial analysis

Start with the hypothesis. The hypothesis drives work on assessing the business and management

Business diligence on the business and management

Learnings from business diligence feed into financial analysis 104

So, in step 1: Understand the business Lessons from business diligence and financial analysis lead to updated hypothesis and conclusions

Hypothesis

Learnings from financial analysis feed into business diligence

Financial analysis

Start with the hypothesis. The hypothesis drives work on assessing the business and management

Business diligence on the business and management

Learnings from business diligence feed into financial analysis 105

Step 2: Understand the expectations implicit in the stock price ““How do you find attractive odds in the investment business? You must locate gaps between current expectations and where expectations will likely stand in the future. While many probabilistic fields post their odds — handicapping and sports betting, for example — stock markets investors must learn to read the odds by deciphering the expectations built into prevailing prices… When a company possesses strong fundamentals, investors tend to buy irrespective of expectations. Similarly weak fundamentals cause investors to avoid a stock. These tendencies lead to an inability to properly calibrate odds, producing suboptimal performance.” - Michael Mauboussin The ‘reverse DCF’, which we will learn about in session 7, is the best tool for this purpose 106

Step 3: Assess the odds Your view of the longterm outlook for the company, based your understanding of the business and management

> ~= <

Market implied expectations embedded in the stock price

107

Step 4: Act if the odds are in your favour Industry growth 6-8%

Company gaining some share over last 5 years

Stock implies 18-20% longterm growth

Very low chance that the implicit expectations will be met

Industry growth 6-8%


Stock implies 12-14% longterm growth

Unclear if implicit expectations will be met

Industry growth 6-8%


Stock implies 46% long-term growth

High likelihood that the implicit expectations will be exceeded

Avoid

Buy

108

A good investment process improves the odds of good outcomes Hypothesis

Financial analysis

Your view of the long-term outlook for the company, based your understanding of the business and management

Business diligence

> ~= <

Likely to lead to fewer mistakes Likely to lead to more good investments

Likely to lead to a good longterm investing track record

Market implied expectations embedded in the stock price

109

Focus on the investment process, not on investment outcomes (1 of 2) •

While the investment process is related to the level of skill, the outcomes associated with any set of investment decisions are affected by both the skill of the decision maker and randomness (i.e., luck)

•

But luck tends to average out over time, and so a long-term investing track record therefore primarily reflects the investors’ level of skill (i.e., the investor’s investment process)

•

So, the right mindset for an investor is ‘process over outcome’

•

A good process helps maximize the odds of ‘deserved success’ – see the table below

Source: Decision-making for investors by Michael Mauboussin, at http://www.retailinvestor.org/pdf/decisionmaking.pdf

110

Focus on the investment process, not on investment outcomes (2 of 2) “While satisfactory long-term outcomes ultimately define success in probabilistic fields, the best in their class focus on establishing a superior process with the understanding that outcomes take care of themselves. Probabilistic endeavours require a focus on process because, by definition, poor decisions will periodically result in good outcomes, and good decisions will lead to poor outcomes.“

Source: Decision-making for investors by Michael Mauboussin, at http://www.retailinvestor.org/pdf/decisionmaking.pdf

111

112




113

What is a hypothesis? (1 of 2) •

A hypothesis is “a proposition, or set of propositions, set forth as an explanation for the occurrence of some specified group of phenomena, either asserted merely as a provisional conjecture to guide investigation (working hypothesis) or accepted as highly probable in the light of established facts.”

•

Developing a hypothesis is thus a key step in the ‘scientific method’ • • • • •

Observation (which often triggers a research question), Hypothesis (a guess about a plausible answer to the question) Experimentation (developing appropriate tests to assess if your hypothesis is valid) Observation (conducting the experiments and collecting their results) Inference (a logical conclusion based on the results of the experiment)

Source: www.dictionary.com/browse/hypothesis

114

What is a hypothesis? (2 of 2)

115

Hypotheses are easier to test in the physical sciences than in business • For example: X observes a dead plant in a dark room, conjectures that the plant may have died due to lack of light and develops an experiment to test this hypothesis • Randomly divide a group of say 100 similar (and healthy) plants of the same species into two rooms, one of which is dark and the other well-lit, and otherwise treat the plants in each room the same way (such as the amount of water and manure that the plants receive) over the next two weeks • At the end of two weeks, observe that plants in the dark room die while those in the well-lit room are alive and healthy • Infer that plants in the dark room died due to lack of light • Hypotheses such as the one above are easily testable in the physical sciences, but testing is usually harder in the world of business (and the world of social sciences more generally)

116

What is an investment hypothesis? • The investment hypothesis (and related sub-hypotheses) can therefore be viewed as a set of provisional conjectures, based on some preliminary background knowledge about a company we are evaluating

117

Investment hypotheses are the starting point of diligence on a company

Hypothesis

Financial analysis

Business diligence

118

Investment hypotheses about a company can be structured into five broad areas 1

Industry

2

Company position and performance

3

Management and governance

4

Risks

5

Valuation

119

How to develop investment hypotheses •

Develop a quick sense of the company’s business, possibly by reading an annual report or investor presentation

•

Review summary historical financial information for at least the last 3-5 years

•

Reflect on what makes this company a good business, and why you like this management team

•

Identify the 4-5 ‘need to believe’ issues that need to be studied in depth

•

Drill down into each of these issues and create sub-hypotheses

•

Identify the types of work / analysis that need to be done on each subhypothesis

•

Make each of the sub-hypotheses ‘testable’

•

Structure the tree of sub-hypotheses into smaller work steams such that the information you gather while exploring each of the individual ‘branches’ rolls up to your investment decision

•

Recognize that some of the sub-hypotheses are more important than others – a key sub-hypothesis (or a group of them) being disproven could lead you to walk away from the investment

120

This is best understood through the example - Colgate-Palmolive India •

Colgate-Palmolive India (‘ India’) is a branded, consumer staples (or FMCG) business, primarily in oral care (toothpaste / tooth brushes)

•

The ultimate controlling shareholder of India - which has been listed in India since 1978 - with 51% of the equity, is Colgate Palmolive Company (which is listed in the US)

•

For background, review the investor presentations at http://www.colgateinvestors.co.in/media/1367/analystpresentation2016 .pdf http://www.colgateinvestors.co.in/media/1362/analystpresentation2017 5faeeba83ef54755b29a2db64f9a4647.pdf and http://www.colgateinvestors.co.in/media/1969/analystpresentation2018 .pdf

•

Then, take some time to draft the investment hypotheses that you think need to be tested before investing in India, before moving to the next slide

121

122

Here are first level hypotheses for Colgate India (as of July 2018)…

Industry

The Indian oral care industry is very attractive


India has a strong operating and financial track record, which is likely to sustain in future


India’s management team is stable and appropriately aligned with minority shareholders

Risks

Valuation

Increased competition (especially from Patanjali in the ‘natural’ toothpaste segment) is the primary risk, which India can fend off India stock trades at an attractive valuation, considering the quality of its business and the risks 123

… which we drill down into subhypotheses (page 1 of 2) Industry


1. The Indian oral care industry is very attractive 1a: Oral care in India has acyclical demand with long runway for structural growth 1b: Oral care has high entry barriers due to the need to (i) build a trusted brand, (ii) set up deep distribution especially in rural India and (iii) constantly develop new products to suit evolving consumer tastes 1c: The consolidated industry structure and the focus of key players on profitable growth lead to high returns on capital and strong cash generation for the industry

2. India has a strong track operating and financial track record, which is likely to sustain in future 2a: India is the dominant market leader with the strongest brand, widest distribution and regular, relevant new product launches 2b: India has held or increased market share over many years, despite new entrants and changing consumer tastes 2c: India has delivered excellent financial results – steady growth with high returns on capital, strong cash generation and sensible capital allocation


3. India’s management team is stable and appropriately aligned with minority shareholders 3a. India’s management team is stable and is incentivized to deliver strong operating results 3b. There are no material red flags on ‘related party transactions’ with other Colgate-Palmolive group companies

124

… which we drill down into subhypotheses (page 2 of 2) Risks

4. Increased competition (especially from Patanjali in the ‘natural’ toothpaste segment) is the primary risk, which India can fend off 4a. Colgate India has lost market share to Patanjali (which is not fully reflected in Nielsen market share data) due to the growing consumer preference for ‘natural’ toothpaste 4b. Colgate India’s launch of ‘Vedshakti’ toothpaste in the ‘natural’ segment has been well-received, and has stemmed the loss of market share 4c. Colgate India has fought off efforts of competitors such as Hindustan Unilever, Dabur and Procter & Gamble (‘P&G’) in the past with little loss of market share, and will likely fend off Patanjali’s efforts too 4d. ‘Natural’ toothpaste is likely to remain a segment of the toothpaste market, and Colgate can stay #1 in oral care even if it is not #1 in the ‘natural’ segment

Valuation

5. India stock trades at an attractive valuation, considering the quality of the business and the risks 5a. Colgate is a ‘compounder’ that is likely to grow at a steady rate with relatively low risk 5b. India is an attractive investment for a long-term shareholder despite the recent loss of market share to Patanjali

125

Sub-hypotheses are broken down further into work streams (1 of 2) Sub-hypothesis

Work stream

Source of info

Priority

1a: Oral care has acyclical demand with long runway for structural growth in India Oral care has acyclical demand

-

-

Oral care has long runway for structural growth in India

-

-

Analyze oral care industry volume and value data for India for the past 10-15 years to assess cyclicality of demand Review industry data from other low-income and middle-income emerging markets to assess cyclicality of demand, if any

- Nielsen market research data

Analyze penetration, per capita consumption volume and per unit price trends for last 5-10 years for tooth brush, tooth powder and tooth paste in India Compare India with other lowincome and middle-income emerging markets to assess runway for growth

- Nielsen market research data

Medium

- Management of India or their competitors, oral care companies in other emerging markets

- Management of India or their competitors, oral care companies in other emerging markets - Data from market research firms like Euromonitor

High

126

Sub-hypotheses are broken down further into work streams (2 of 2) Sub-hypothesis

Work stream

Source of info Priority

2b: India has held or increased market share over many years, despite new entrants and changing consumer tastes India has held or increased market share over many years despite new entrants

-

India has not faltered despite new entrants and changing consumer tastes

-

-

-

-

-

-

Analyze Nielsen survey data to track India’s market share over 10-15 years Deep dive in particular into significant decreases in India market share (such as to Hindustan Unilever Limited (‘HUL’) during 1999-2004), and how India was able to recover subsequently Deep dive into periods where a credible new player (such as P&G) entered the market – how did India react and what was the impact on India’s market share

- Nielsen market research data, adjusted for Patanjali sales - Annual reports of India and HUL for 1999-2004 - Press articles from 1999-2004 / 2013 - Employees of P&G/ HUL / / Dabur

Medium

Analyze movements in the share of newer sub-segments of the oral care market (such as gels, ‘naturals’, sensitive) over time Assess if the growth in these sub-segments was led by India, or whether India was responding to competition If India is a follower in newer segments, assess how quickly did it take to become a credible player / leader in these segments Understand how India launched ‘naturals’ that are not in ’s global portfolio

- Nielsen market research data, adjusted for Patanjali sales - Annual reports of India and competitors - Current / former employees of India and competitors

High

127

128

Food for thought: 1 of 1

Food for thought

• We have seen a few examples of going from hypotheses to subhypotheses, and identifying the work streams that can help assess a sub-hypothesis (see examples for sub-hypothesis 1a and 2b above) • Pause here, and assess how to test the following sub-hypotheses

• 3b. There are no material red flags on ‘related party transactions’ with other Colgate-Palmolive group companies • 4a. Colgate India has lost market share to Patanjali (which is not fully reflected in Nielsen market share data) due to the growing consumer preference for ‘natural’ toothpaste • We will discuss this in class

129




130

While gathering information to prove / disprove your hypothesis, it is better to start with the ‘facts’ before getting into the ‘story’ “I teach my students and analysts: start first with the SEC filings, then go to press releases, then go to earnings calls and other research. Work your way out. Most people work their way in. They’ll hear a story, then they’ll read some research reports, then they’ll listen to some conference calls, and by that point may have already put the stock in their portfolio. It’s amazing what companies will tell you in their documents… This way you are looking at the most unbiased sources first. People on earnings calls will try and spin things, and analyst reports will obviously have a point of view. All of that is fine, because hopefully you will have first read the unvarnished facts. Primary research is crucial and not as many people do it as you think. Because there is so much information out there, it almost behooves people to read the source documents.”

- Jim Chanos, Kynikos Associates

https://www8.gsb.columbia.edu/sites/valueinvesting/files/files/Graham%20%26%20Doddsville%20-%20Issue%2015%20-%20Spring%202012.pdf

131

There are many ways – some more reliable than others – to understand a company during the diligence process Relatively less reliable sources, produced by the company

Annual reports

Regulatory filings

Relatively more reliable sources, not ‘managed’ by the company

Exemployees

Industry experts

Conference call transcripts

Meetings with management

Investor presentations

Press releases

Competitors

Vendors

Customers

Physical visits to stores

132

A short detour: evidence and validating a hypothesis No amount of evidence can conclusively prove a hypothesis

Evidence Evidence Evidence

Prove a hypothesis

Evidence

… but a single piece of evidence can disprove a hypothesis

Evidence

Disprove a hypothesis

133

In 1650, you could not confirm the hypothesis that all swans are white…

In the mid 1600s, every person in London believed that all swans were white in colour – those were the only colour they had ever seen!

134

… but the sighting of a black swan in 1697 (in Australia) disproved it

The metaphor of the ‘black swan’ was popularized by Nassim Taleb in his must-read books ‘Fooled by Randomness’ and ‘The Black Swan’ 135

In summary: evidence and validating a hypothesis

“No amount of experimentation can ever prove me right; a single experiment can prove me wrong.” - Attributed to Albert Einstein

136

The right way to test investment hypotheses During diligence, investors tend to seek out evidence that confirms their hypothesis… Evidence Evidence Evidence

Prove a hypothesis

Evidence

… while they should instead actively be seeking out DISCONFIRMING evidence which is contrary to their hypothesis Evidence

Disprove a hypothesis

We will look at this issue in greater detail in session 11, but it is important to keep this in mind through the rest of the course 137

138

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