1 approaches to investing long termshort termefficient market fundamental (value) levels mkt. price...
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1
Approaches to Investing
Long Term Short Term Efficient Market
Fundamental(Value)
Levels
• Mkt. Price vs. Value
We Are Here
Fundamental(Value)
Technical
• Momentum
• Price/Volume Patterns
Changes
• Current Price + Forecast Change
• Micro
• Macro
• Asset Allocation
• Cost Minimization
Relative Rarely Done Well(Shliefer, Vishny, Lakonishok)
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Essentials of Value InvestingLong-Term Fundamental (Look at Underlying Businesses)
Specific Premises:
• Mr. Market is a Strange Guy
Prices diverge regularly from fundamental values
• You Can Buy Underpriced Stocks
Fundamental values are often measurable
• Fundamental Value Determines Future Price
Buying underpriced stocks plus patience implies superior returns
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Real S&P 500 and Trend
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Value Investing in Practice
1) Look Intelligently for Value Opportunities (low P/E, M/B)
2) Know What You Know
3) You Don’t Have to Swing
• Value Implies Concentration not Diversification (look for Margin of Safety)
• At Worst, Buy the Market
• Not All Value is Measurable
• Not All Value is Measurable By You (Circle of Competence)
• Mr. Market is not Crazy about Everything
• This is the first step not to be confused with Value Investing
Long-Term Fundamental (Look at Underlying Businesses)
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Microsoft Valuation (in 2000)
Assume: 50% dividend payout (now zero) 40% annual growth in sales, earnings (by 2010 – 28 times
current size) 15% discount rate (15% desired return)
15%Value
Terminal Value
(depends on conditions in 2010 & beyond)
Valuation:
2000 2010
Dividends
85%Value
Value = current price (i.e. 110) 80x earnings.
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Value Investing the Approach
Value
Review
Manage Risk
Search(Look systematically for undervaluation)
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Search Criteria
• Obscure −Small Capitalization−Spin-Offs−Boring (Low Analyst Coverage)
• Undesirable
• Supply, Demand Imbalance - RTC
−Financial Distress, Bankruptcy
−Low Growth, Low P/E, Low M/B
−Industry Problems (Bad Loans, Regulatory Threat, Overcapacity)
−Company Problem (Lawsuit, Poor Subsidiary Performance, Poor Year)
−Disappointing (Long-Term Under performance)
−Privatizations
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Stocks as Underpriced Assets
• Stocks historically outperform bonds, etc.
• Stocks are not that much more risky
But today…
Stocks: E/P = 4% + 1½ % = 5½ % vs. 11%
Inflation Historical
Bonds: 5% vs. 3½ % at comparable inflation rates
Notes: 4 ½ % vs. 2%
Stock under valuation not so clear
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Systematic Biases
1. Institutional
Herding – Minimize Deviations
Window Dressing (January Effect)
Blockbusters
2. Individual
Loss Aversion
Hindsight Bias
Lotteries
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Loss Aversion - Example
• In addition to whatever you own, you have been given $1000. Choose Between:
– $1000 with Prob .5$ 0 with Prob .5
– $500 with Certainty
• In addition to whatever you own, you have been given $2000. Choose between:
– -$1000 with Prob .5 $ 0 with Prob .5
– -$500 with Certainty
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Summary of Search
Value
Review
Manage Risk
Search(Look systematically for
undervaluation)
• Low M/B, P/E, Growth
• Disappointing Rtns
• Institutional Psycho
• Logical Rationale
• Obscure
• Undesirable
• Supply-Demand Imbalance
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Value Investing the Approach
Value
Review
Manage Risk
Search(Look systematically for undervaluation)
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Valuation Approaches – Ratio Analysis
Cash Flow Measure
Earnings
(Maint. Inv. = Depr + A)
EBIT
(Maint. Inv. = Depr + A; Tax =0)
EBIT - A
(Maint. Inv. = Depr only)
EBIT-DA
(Maint. Inv. = 0)
Multiple
Depends on:
• Economic position
• Cyclical situation
• Leverage
• Mgmt. Quality
• Cost of Capital (Risk)
• Growth
x
Range of Error (100%+)
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Valuation ApproachesNet Present Value of Cash Flow
Value = CFt = CF0
11 + R( )t 1
R - g *
t=0
Note: NPV Analysis encompasses ratio analysis(NPVdiseases are ratio analysis diseases)
Note: NPV is theoretically correct
Revenues
Margins
Required Investments
Investment
Cash Flows
Cost of Capital
NPV </> Market Value
Parameters:
Market Size
Market Share
Market Growth
Price/Cost
Tech
Management Performance
Forces:
Consumer Behavior
Competitor Behavior
Cost Pressures
Technology
Tech
Management Performance
In Practice:
X
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Shortcomings of NPV Approach in Practice(1) Method of Combining Information
(2) Sensitivity Analysis is Based on Difficult-to-Forecast Parameters which co-vary in fairly complicated ways
NPV = CFo +CF1
1
1 + R 1 + R+ … +CF20
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1+ ...
Good Information (Precise)
Bad Information (Imprecise)
= Bad/Imprecise Information
Profit Margin
Cost of Capital
Growth
Required Investment
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Valuation Assumptions
Traditional:
• Profit rate 6%
• Cost of capital 10%
• Investment/sales 60%
• Profit rate +3% (i.e. 9%)
• Growth rate 7% of sales, profits
Strategic:
• Industry is economically viable
• Entry is “Free” (no incumbent competitive advantage)
• Firm enjoys sustainable competitive advantage
• Competitive advantage is stable, firm grows with industry
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Value InvestingBasic Approach to Valuation
“Know what you know”; Circle of competence
1. Organize valuation components by reliability
Most Reliable Least Reliable
2. Organize valuation components by underlying strategic assumption
No Competitive Growing CompetitiveAdvantage Advantage
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Basic Elements of Value
Strategic Dimension
Growth in Franchise Only
Franchise ValueCurrent Competitive Advantage
Free EntryNo Competitive Advantage
Asset Value Earnings Power Value
Total Value
• Tangible• Balance Sheet
Based• No
Extrapolation
• Current Earnings
• Extrapolation• No Forecast
• Includes Growth
• Extrapolation• Forecast
Reliability Dimension
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Industry Entry - Exit
Remember, Exit is Slower than Entry.
Industry Market Value Net Asset Value Entry
Chemicals $2B $1B Yes (P MV )(Allied) $1.5B $1B Yes
$1.0B $1B Stop
Automobiles $40B $25B Yes (Sales MV)(Ford) $30B $25B Yes
$25B $25B Stop
Internet $10B $0.010B ?
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Asset Value
Assets
Cash Book Book
Accounts Receivable Book Book + Allowance
Inventories Book Book + LIFO
PPE 0 Orig Cost Adj
Product Portfolio 0 Years R & D
Customer Relationships 0 Year SGA
Organization 0
Licenses, Franchises 0 Private Mkt. Value
Subsidiaries 0 Private Mkt. Value
Liabilities
A/P, AT, AL Book Book
Debt Book Fair Market
Def Tax, Reserves Book DCF
Bottom Line Net Net Wk Cap Net Repro Value
Reproduction ValueBasic Graham-
Dodd Value
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Asset Value Approaches
Remember, Low M/B is very hard to beat.
Opportunities None Limited More Extended
Value in Practice Yes Yes Yes
Industry Knowledge None None Extensive
Stability/Reliability High Low Intermediate
Goodwill 0 Historical Reproduction
Debt Book Book Est Market(Low Debt) (0 Enterprise) (0 Enterprise)
Approach Graham Book Reproduction
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Asset Value Issues
• Management
• Private Market Values
• Reproduction vs. Book
• Non Viable Industries
• Good adds value
• Bad subtracts value
• Potentially highly unstable (EBITDA multiples of Internet subs)
• Better where accountants misestimate
Tech trendsReal estateIntangibles
• M/B indicator close to M/Repro value
• Improvement requires discipline
• Value = Zero (except NWC)
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Asset Value Risk Management
• Private biases
• Catalysts
• Importance of industry knowledge
• Hedging
• Personal computer industry
• Psychological experiments
• Evidence of investment behavior in life
• Takeover
• Reorganization
• Management change
• If don’t know, don’t play (Circle of Competence)
• Limited
Ultimately, “Margin of Safety” is risk management tool
(Otherwise diversify)
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Earning Power Value
Basic Concept – Enterprise value based on this years “Earnings”
Measurement
– Earnings Power Value = “Earnings”
Second most reliable information earnings today
Calculation
– “Earnings” – Accounting Income + Adjustments
– Cost of Capital = WACC (Enterprise Value)
– Equity Value = Earnings Power Value – Debt.
Assumption:
– Current profitability is sustainable
1Cost of capital*
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Earning Power Value Adjustments
“Earnings” = EBIT (From Financial Statement)
+ One Time Charge Adjustment (if charges before tax average 20% of EBIT – 5 years – then reduce EBIT by 20%)
+Cyclical Adjustment (calculate peak-to-trough EBIT variation – say 20% of average. If a peak subtract 29% of EBIT)
+Tax Adjustment (apply average tax rate to EBIT – debt tax shield in WACC)
+ Depreciation Adjustment (Depr + Amort – Zero Growth Capex)
+ Subsidiary Earnings Adjustments
+ Other Adjustments (Temporary Problem, Unused Pricing Power).
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Earning Power Value Calculation
WACC = Cost of Capital = (Fraction of Debt) (RD) (1-Tax) + (Fraction of Equity) (Cost of Equity)
Fraction of Debt = 1- Fraction of Equity Actual or Potential
Zero Growth Capex = Actual Capex - Growth Capex
Growth Capex = (PPE/Sales) * Sales
Balance Sheet
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Earning Power and Entry - Exit
Asset Value EP Value
Case B: Free EntryIndustry Balance
Case A:
Asset Value EP Value
Value Lost to Poor Management and/or Industry Decline
Asset Value EP Value
Case C: Consequence of Comp. Advantage and/or Superior Management
“Sustainability” depends on Continuing Barriers-to-Entry
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Franchise Value Calculation
(A1) Cost of Capital = 10%
(A2) Asset Value “AV” = 1200M
(A3) Earnings Power Value = 2400M = 240M X (1 / 10%)
“Earnings”
• Competitive “Free Entry Earnings” = 120M = Cost of Cap. X Asset
V = 10% x 1200
• Franchise Earnings = “Earnings” – “Free Entry Earnings”
= 240 - 120
= 120
(A4) Sales = 2000M (Tax Rate = 40%) Power Value = 2400M = 240M X (1 / 10%)
• Franchise Margin = 120M ÷2000M = 6% after tax
• Franchise Margin (pre-tax) = 10% = (10% - 40% X 10% = 6%)
Tax
EP Value Implies Sustainable 10% Cost and/or Pricing Advantage
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Earnings Power Value Issues
Nature and sustainability of barriers-to-entry (competitive advantage)
Sustainability of management quality
Quality of reinvestment opportunities
Value of cash
–Subtract interest earned from
–EBIT add
–Cash to EP value
Inflation adjustment
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“Real” Earning Power Value
“Real” Earnings = “Earnings” – Inflation driven Investment
“Real” Cost of Capital = WACC – Inflation Rate
Inflation Driven Adjustment = Net Assets (Not including ‘goodwill’ items) * Rate of Inflation
Example:
(A1) EP Value = 2400M = 240M * 10%
(A2) Net Assets (not including goodwill) =
Cash + AR + Inv. + PPE – A/P – AL – AT = 800M
(A3) Inflation rate = 2%
• Inflation Driven Adjustment = 2% * 800M = 16M
• “Real” Earnings = 240M – 16M = 224M
• “Real” Earnings Power = 224 = 224 = 2800M
10% - 2% 8%
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Summary of Basic Valuation
Compute: Asset Value (Most reliable)
EP Value (Second most reliable)
Case A: Asset Value EP Value Value = EP Value
(500M) (300M) + Catalyst Value
Case B: Asset Value = EP Value Value = 500M
(500M) (500M)
Case C: Asset Value EP Value Value = Asset Value
(500M) (1000M) + Sustainable Fractionof Franchise Value (1000M-500M)
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Summary of ValuationStrategic vs. Traditional Approach
Market Size Estimate
Market Share
Operation Margin
Investment
Cost of Capital
Value
Traditional
Revenue
Oper Income (EBIT)
Cash Flow
NVP
National Income,Growth, Consumer Trends
Competitive Responses; Entry/Exit
Technology, Costs;Prices; Input Costs
Technology, Growth
Financial Market Conditions; Risks
Strategic: Is this the South Bronx of the Investment World?
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Basic Strategy FrameworkPorter Five Forces – Probability Determinants
Four Forces too many
Substitutes
CustomerSuppliers
Entrants
Industry Competition
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Strategic Investment Forces
• Entry-Expansion – Barriers-to-Entry“Incumbent Competitive Advantage”
Does this company enjoy competitive advantage that is significant?
Yes – Being industry creates value No – Efficient Operation may create value Others enjoy advantage – stay out. (Being in industry
destroys value)
What about entrant advantages? No good – after entry you become incumbent.
• Existing Competitor Dynamics Degree of Competition (Phillip Morris)
• Share the Wealth (Workers, Customers) Value Chain Dynamics
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Consequences of Free EntryCommodity Markets (Steel)
$/Q
QFirm Position
Price
AC “Economic Profit”
ROE (20%) > Cost of Capital
Entry/Expansion
Supply Up, Price Down
$/Q
QFirm Position
Price
AC
(Efficient Producers)
ROE = 12%
No Entry
No Profit
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Consequences of Free EntryDifferentiated Markets (Luxury Cars)
$/Q
QFirm Position
Demand Curve
AC“Economic Profit”
ROE (20%) > Cost of Capital
Entry/Expansion
Demand for Firm shifts left (Fewer sales at each Price)
$/Q
QFirm Position
Demand Curve
AC
ROE = 12%
No Entry
No Profit
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Barriers to EntryIncumbent Cost Advantage
Entrant Incumbent Sources
No “Economic” Profit
ROE = 12%
No Entry
“Economic” Profit
ROE = 20%
Proprietary Tech(Patent, Process)
Learning Curve
Special Resources
• Not Access to Capital
• Not Just Smarter
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Barriers to Entry
Incumbent Demand Advantage
Entrant Incumbent Sources
No “Economic” Profit
ROE = 12%
No Entry
Higher Profit, Sales
ROE = 20%
Habit (Coca-Cola)
• High Frequency Purchase
Search Cost (MD’s)
• High Complex Quality
Switching Cost (Banks, Computer Systems)
• Broad Embedded Applications
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Barriers to Entry
Economies of Scale
• Require Significant Fixed Cost (Internet)
• Require “Temporary” Demand Advantage
• Not the Same as Large Size (Auto + Health Care Co)
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Barriers to Entry
Economies of Scale
• Advantages are Dynamic and Must be Defended
• Fixed Costs By:• Geographic Region (Cohrs, Nebraska Furniture
Mart, Wal-Mart)
• Product Line (Eye Surgery, HMO’s)
• National (Oreos, Coke, Nike, Autos)
• Global (Boeing, Intel, Microsoft)
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Barriers to Entry - Sustainability
Static Demand Advantages
•Tied Customers
Exploitation
•Pricing, focus on “Own” Customers
•No advantage with Virgin customers
•Shrinkage over time as base changes
•Cost efficiency in “Own” technology
•No advantage with virgin technology
•Shrinkage with technology change
Static Cost Advantages
Economies-of-Scale + Dynamic Demand Advantage
• Principal sustainable advantage
• Constant vigilance
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Other Barriers-to-Entry
• Government, Regulatory, Public
(Lead based Gas Additives; Cigarettes)
• Informational (Who Knows What)
(Banks, Financial Services, HMO’s)
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Performing Strategic Analysis
Industry Map
Do barriers Exist?
What Competitive
Advantages?
Future Strategy, Profitability
(1)
(2)
(3)
(4)
Identify Industry
Industry History
Demand? Cost? Economies-of-Scale?
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Performing Strategic AnalysisApple Computer - Industry Map
Industry:
• Identify SegmentsStep 1:
For Apple Segment Are:• Chips• Hardware• Software
Step 2:
Step 3:
Chips
Components
Hardware Software Networks
Intel, AMD, Motorola, Apple
Dell, HP, Gateway, IBM, Compaq, Apple
Microsoft, Apple, Oracle, Netscape
AOL
Power Supply Co.’s, etc.
• Identify firms in each segments
• If firms are the same, treat segments as Single Industry
•If firms are different, treat segments as Separate industry
•If in doubt, treat segments as separate industries
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Performing Strategic Analysis
Do Barriers/Competitive Advantage Exist
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Performing Strategic Analysis
Nature of Barriers-to-Entry Competitive Advantage
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Other Strategic Considerations
Cooperation within Barriers
–Coke – Pepsi
–Cigarette Makers
Division of Spoils in Value Chain
–Strategic alliances
–You can not take home, if you don’t bring (NuKote)
–Employee Power (unions, Prof. Services firms)
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Summary of Strategic Investment
Without Competitive Advantage – no Value in Franchise
Competitive Advantage must be identifiable and sustainable
In particular, Are existing Competitive Advantages Sustainable or are they likely to erode?
If in doubt, do not pay for franchise
Ideally look for ‘hidden’ franchise–Unused pricing power (Coke, Cereals)
–Poorly performing divisions
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Total Value Including Growth
Least reliable - Forecast change not just stability (Earnings Power)
Highly sensitive to assumptions
Data indicates that investors systematically overpay for growth
Strict value investors want growth for “Free” (Market Value < Earnings Power Value)
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Value of Growth - Basic Forces At Work
• Growing Stream of Cash Flows is more Valuable than a Constant Stream (relative to current Cash Flow)
• Growth Requires Investment which reduces current (distributable) Cash Flow
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Value of Growth - Basic Algebra
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Valuing Growth
Case 1: ROC Return on Capital Cost of Capital R Then ROC – G R – G
R – G R – G= 1 (for all growth rates)
ROC = R when there are no Barriers-to-Entry (i.e. no competitive advantages – level playing field) then Growth has no Value.
ROC – G 10 - 0R-G 10 - 0
= = 1 G = 0%
ROC – G 10 - 2R-G 10 - 2
= = 1 G = 2%
ROC – G 10 - 8R-G 10 - 8
= = 1 G = 8%
e.g. (ROC = R = 10%)
=
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Valuing Growth
Case 2: Competitive disadvantage with growth
ROC less than cost of capital then ROC – G < R - GROC – G < 1
R – G and ROC – G gets smaller with higher growth rates.
R – G
Higher Growth at a Competitive
Disadvantage Destroys Value
ROC – G 8 - 0R-G 10 - 0
= = .8
G = 0%
ROC – G 8 - 2R-G 10 - 2
= = .75 G = 2%
ROC – G 8 - 8R-G 10 - 8
= = 0 G = 8%
e.g.
(ROC = 8%, R=10%)
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Valuing Growth
Case 3: ROC is greater than R – Firm enjoys a competitive
advantage (franchise)Shares are stable G = Industry Growth Rate
then ROC – G is greater than R – G and ROC – G is greater than 1 and increasing in G.
R – G
Only within Franchise Growth creates Value
ROC – G 15 - 0R-G 10 - 0
= = 1.5 G = 0%
ROC – G 15 - 2R-G 10 - 2
= = 1.625 G = 2%
ROC – G 15 - 8R-G 10 - 8
= = 3.5 G = 8%
e.g. (ROC = 15%, R = 10%)
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Valuing Growth Basics
Growth at a competitive disadvantage destroys value (AT&T in info processing)
Growth on a level playing field neither creates nor destroys value (Wal-Mart in NE)
Only franchise growth (at industry rate) creates value
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Valuing Growth - How much Does it Add?
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Valuing GrowthHigh (Unstable) Growth
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Valuing Growth Breakeven Growth Rate
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Valuing GrowthKeep-In-Mind
Very hard to do
Very hard to determine margin of safety
Evidence is that Investors systematically overpay
Best growth is hidden (zero cost growth)
Unused pricing power
Temporary problem
Underperforming divisions
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Summary of Valuation
Value
Review
Manage Risk
Search(Look systematically for undervaluation)
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Managing Risk – Overall Valuation
Review biases
Look for asset protection
Adequate margin of safety (1/3)
Identify catalysts (create catalysts?)
Appropriate search rationale
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Summary of Valuation
AssetValue
EPValue
Growth
Value
MV < AV, EPV
AV < MV < EPV
AV, EPV < MV
BUY Assess Comp. Adv.
Lots of Luck
Lots of Luck
BUY
Sustainable?
NoYes
Most certain
but mgt.?
Medium certain
Sustainable?
Uncertain
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Summary of Valuation
Strategic Dimension
Growth in Franchise Only
Franchise ValueCurrent Competitive Advantage
Free EntryNo Competitive Advantage
Asset Value Earnings Power Value
Total Value
• Tangible• Balance Sheet
Based• No
Extrapolation
• Current Earnings
• Extrapolation• No Forecast
• Includes Growth
• Extrapolation
• Forecast
Reliability Dimension
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