Wednesday, September 6, 2017

Book Review #31: The Little Book of Value Investing: Author: Christopher H Browne


Over 176 pages and 21 Chapters,  the book 'Little Book of Value Investing' by Christopher Browne packs quite a punch. Content rich, this book has insights in almost every page. This is a kind of 'Intelligent Investor' on Steroids.
Chapter 1: Buy stocks like steaks....on sale
Value investing is an approach of buying stocks which are trading well below the intrinsic value. It is a model that will help identify good companies at attractive valuations
It is like buying items on sale
The opposite approach is the Growth Investing that focuses on the fads of the day. One normally pays higher price for growth stocks
Over any time period, Value Investing has outperformed growth investing
Chapter 2: What's it worth?
Value investing involves two fundamental principles: Intrinsic Value and Margin of Safety
This chapter focus on the Intrinsic Value
Intrinsic value can be defined as a price paid in an arms length transaction between a knowledgeable buyer and a knowledgeable seller.
Understanding of Intrinsic value helps the investor to sell Over priced stocks and buy underpriced stocks (relative to Intrinsic Value). Intrinsic value helps investor take advantage of mispricing in stocks.
Two approaches to identifying Intrinsic Value: One, Ratio method, by looking at a set of financial ratios and two, Appraisal method, analysing like a banker appraising the value of the business.
Chapter 3: Belts and Suspenders for Stocks
The focus of this chapter is on Margin of Safety.
If you buy a stock at a significant discount to its intrinsic value, you have a margin of safety. If you buy a stock with a margin of safety, there are two ways in which you will benefit. One, as the gap between your purchase price and intrinsic value narrow and two, due to the secular increase in intrinsic value of the company.
Graham used to by stocks selling at two thirds or less of their intrinsic value. It was his marging of safety for two reasons. One, the stock could rise 50% and will still be trading around the intrinsic value. Also, if the market hit a rough patch, he had the comfort of knowing that what he owned was worth more than what he paid for.
Margin of safety also prevents investors from taking too much risks, for example, investing in companies with high amount of debt. Margin of safety also prevents the investor from excessive concentration in individual stocks by encouraging diversificattion. Margin of safety also allows you to be a contrarian. During negative events, when there is overall gloom around, focusing on Margin of Safety will throw up wonderful opportunities to invest in.
Finally Margin of safety not only applies to buying shares, but also applies to selling them. You sell stocks when they are priced above their intrinsic value.
Chapter 4: 
The starting point to find value is to identify companies trading at low PE ratio. Inverse of PE ratio is called Earnings yield which helps compare investment opportunities. The advantage of buying low pe stocks is that negative expectations are factored in and any positive news can bump up the stock price significantly. Reverse is true for high pe stocks. Good news will have no impact on their price while any bad news can bring down their share price dramatically.
Chapter 5: 
Another value investing approach is to buy stocks trading below their networth. The ratio is price to book value. This was a favorite of Ben Graham. The assumption here is that the companies will strive to improve their book value and sooner market value will catch up with the book value. This is a good ratio to evaluate companies in banking and financial services.
Chapter 6: 
Why should you go global? The reason is that more than 50% of the world's largest companies are outside of US. For a value investor, this is too big a market to ignore.  One of the benefits of trading in international markets is portfolio diversification. There are other advantages. One, due to legal requirements, the valuation criteria could be different, for example valuing the asset at costs as against market value. Another could be due to different valuation approaches, for example Europe follows a top down, macro economy based valuation while us follows stock specific bottom up valuation. Also country specific issues could provide value investing opportunities.
Chapter 7: 
While global markets provide portfolio diversification, it is not necessary that a value investor should invest in all markets. The author is comfortable investing in developed markets with democratic, capitalistic traditions. Author shuns emerging markets because of their lack of transparency and impulsive decision making. 
Chaper 8: 
Stock purchases by company insiders is an early indicator of potential value mismatch. If this is accompanied by low price to book value, it is a due sign that  things could turnaround soon. As per author selling by insiders is not as predictive. Another way companies could signal value is buy announcing a buy back. A buyback, especially when done below the book value can increase the share price. Other types of investor purchases to look out for are when someone buys more than five percent of the stocks in the company or purchases by an activist investor. Some times purchases by knowledgeable investors are the catalysts required to unlock value.
Chapter 9: 
Correction, both market and stock specific, is a great oportunity to pile on good stocks at bargain prices. Good companies with strong balance sheets tend to recover quickly from downturns. One should be careful not to catch a falling knife.
Chapter 10: 
Today technology offers opportunities to identify stocks reasonable valuation. Ben graham used to trade in stocks that were selling at two thirds of their net current assets. One of the information to look for the buying history of the mutual fund managers who run value funds. Another one maybe to look for merger and acquisition in the industry. Which technology it has become much easier, and paradoxically much more difficult, to identify the new value opportunities
Chapter 11: When is a bargain not a bargain? 
One of the reasons why stocks become cheap is when they have high amount of debt on their balance sheet. As per Graham the debt to equity ratio should be less than 0.5. Another reason for low price could be when the company misses earnings estimate. Stocks in cyclical industries maybe under priced due to cyclical downtown and could take a long time for the cycle to reverse. Other reasons could be adverse labour contracts, under funded pension, increased competition, product obsolescence etc. One of the worst reasons for share price drop is corporate accounting fraud.
So how can we protect our money?
One stick to industries that we know and understand. Two, look for moat also known as competitive advantage. The favourite industries of the author are banks and consumer staples. The most important suggestion is this chapter is to set up a 'no thank you' file of big companies that you want to avoid investing in.
Chapter 12: 
From this chapter we are getting into the realm of financial analysis. We start by analysing the balance sheet. The key aspects in balance sheet are liquidity and debt.  There are two ratios related to liquidity.  First is current ratio is calculated by dividing current liabilities from current assets.  The ideal value is 2. The second ratio is called the quick ratio (also called acid test ratio) which is calculated by the formula current assets minus inventory divided by current liabilities.  The ideal value is 1. These ratios should not be looked in in isolation.  It is important to to compare with peers in the the industry as well as trend within the company.  For example progressively deteriorating ratio could signal potential issue.
When it comes to debt,  the key ratios are the leverage ratios and coverage ratios. Leverage is shown by Debt by Debt to equity ratio.  This ratio could vary from industry to industry but in general the lower the ratio the better.  The important coverage ratios are interest coverage ratio and financial charges coverage ratio.  The higher the coverage ratio the better.
Ask with liquidity ratios we should look for comparative values with the peers as well as Trends within the same company.
Earlier we discussed the importance of book value. Book value is, in general, calculated as total assets minus total liabilities. The higher the value the better. While calculating the total assets one should ignore intangible assets like goodwill. If long term liabilities are growing faster than the long term assets it's a warning signal.
Balance sheet analysis is just the first step. A true balance sheet is a sign of companies strength, its ability to withstand temporary downturns. Next step analysis of income statement. 
Chapter 13: 
First step is to look at at look at to look at at the revenues are the revenues increasing or decreasing? Also look at the segment wise revenue.  It is possible that a profitable segment is hiding the inefficiencies in other segments.
Next look at at the cost of good sold look for the trains is cost of good sold as a proportion of sales increasing and decreasing remaining stable increasing proportion of cost of good sold could indicate that the company is not able to pass on the cost the customers
The difference between the revenue and the cost of good sold is good sold is is called gross profit gross profit margin is calculated by dividing gross profit on the sales look for a steady gross profit margin
Operating profit is calculated by reducing selling and other administrative cost from the gross profit declining operating profit could indicate management that is not able to control the overheads
Other income is a key component that one should be careful about this is a non recurring income and should be removed from the net profit calculation
Net profit is calculated by reducing taxes interest and other income from the operating profit net profit margin is calculated by dividing net profit by the sales. Look for stable or increasing net profit margin.
Earnings per share is calculated by dividing the net profit by the number of shares outstanding. One should look for fully diluted earnings per share which also considers potential increases in shares outstanding through stock options or warrants. A significant difference between regular EPS and fully diluted EPS is a strong warning signal.
As discussed in the previous chapter trends are more important than standalone values
Chapter 14: Send your stocks to the Mayo Clinic
Once you identify potential investment opportunity, it is time to dig deeper by putting the company through a rigorous analysis. There are 16 groups of questions that one should ask of the company under analysis.
1.      What is the outlook of pricing for company’s products? Can company rise prices without impacting volumes?
2.      Can the company sell more without incurring additional costs?
3.      Can the company increase profits on existing sales by cutting down costs, for example. Can the company control its costs? For instance, cookie company has no control over sugar prices
4.      Can the company control expenses like SG & A?
5.      If the company raises sales, how much of it will go into bottom line? Company can increase sales by giving discounts. However, this will not improve the profitability of the company
6.      Can the company be as profitable as it used to be, at least as profitable as its competitors?
7.      Does the company have one time expenses or income that will not repeat in future?
8.      Does the company have unprofitable operations that they could shed?
9.      Is the company comfortable with wall street’s earnings estimate?
10.  How much can the company grow over the next 5 years? How will it achieve the growth? Do the management have a realistic plan to achieve the growth?
11.  What is the plan for the excess cash?
12.  What does the company expect its competitors to do?
13.  How does the company compare financially with other companies in the same business?
14.  What is the resale value of the company?
15.  Any plans to buyback its stock?
16.  What are the insiders doing?
Chapter 15: When in Rome....
If you are following a global approach to value investing, it is imperative to know the different accounting standards being followed by different countries. This accounting difference could throw out some good surprises.
Chapter 16: Trimming the hedges.
When you are investing in international markets, you are incurring three types of risks, one is the stock specific risk, two is the Systemic Market Risk and three, currency risk. Currency risk in international investing is the risk that the currency being used to invest will move in a direction that is detrimental to the investment.
Let us assume that you invest 100 USD in India Market. You covert it to INR @65 and invest 6500 in Sensex. After One year your investment has grown to 7000. You sell and convert the same to USD.
At the time of selling,
If INR / USD is 70 (INR has depreciated), you end up with 100 USD. No gain
If INR has depreciated to 60, you end up with 116 USD, a gain of 16%.
So you know that as a foreign investor, you will face losses if the home currency depreciates. You can handle this potential losses by hedging, for example by selling Indian Currency forward contracts. In this case you are both long (by buying stocks) and short (selling currency forward contracts), so that you are hedged against exchange rate risk.
Another point of view is that if you are invested for the long term, the exchange rate fluctuations tend to cancel each other out (for example in the last 4 years, INR USD has seen a high of 70 and a low of 63) and hence it does not matter if you are hedged or not.
Chapter 17: It is a marathon, not a sprint
The key point in this article is never to time the market. Do not try short term trading,  stay invested in your value picks. In a study conducted in the US market, in a span of 60 months, most of the gains have come in about 7% of time. The remaining 93% of time produced scanty returns.
(On a personal note, my investment in Sterlite Technologies is an example. I purchased this stock at around 60, 5 years ago. In these 5 years stock had jumped about 4 times to around 240 today. However, a huge part of that jump came in a span of about a month.)
Short term trader also end up losing on brokerage, commissions and taxes. World over, short term capital gains are taxed at a higher rate than long term capital gain.
So in summary, invest, do not trade.
Chapter 18: Buy and hold? Really?
This chapter considers the important aspect of asset allocation, specifically between equity and debt. Traditionally there are generic rules like ‘100 – Age’ to decide the proportional allocation between the two. If your age is 30, 70% (100 – 30) should be allocated to equity and balance to debt.
Author is not in favour of these approaches. Being a firm believer in equity investing and the power of compounding, his solution is simple. Be predominantly invested in equities. Keep a three year debt investment that will give you commensurate returns based on your expenditure expectations. Invest the remaining in equity. When the equity is increasing, use the returns from the equity to meet your monthly expenditure needs. You should dip into your debt investment (nest egg) only when equities are down. In case you take money out of your nest egg, top it up as soon as markets start moving up again. This approach will help you to capitalize yourself with equity return when the markets are going up and with debt returns when markets are going down and equity has to be conserved.
Peter Lynch, in his book ‘Beating the street’, suggests 100% allocation into equities and taking money out of equity irrespective whether market is up or down. The suggestion by the author is just a minor tweak on the suggestions by Lynch.
I like this approach. Very practical.
Chapter 19: When only a specialist will do
The secret to winning the investment game is to pick good managers and stick with them. If you are not a financial wizard who does his own investing, the chances are that you will require an investment manager sooner or later. A good manager can add significant percentage points to your returns. This chapter focus on the questions to ask while selecting the fund manager. There are four sets of questions  / criteria that you have to evaluate before you select a fund manager.
1.      Simplicity of investment approach. The manager must be able to explain his investment approach in simple language without confusing the listener with jargons. The simplicity in the answers show the clarity of thought.
2.      Track Record: You have to look at the track record through a complete market cycle to gauge the capability of the manager
3.      Is the fund manager still with the fund or the track record in point 2 above is of a different fund manager who has moved on?
4.      Investing own money: Where do fund managers invest their own money? Is the approach consistent
Chapter 20: You can lead a horse to water but....
It is beyond doubt that Value Investing has proven to be an excellent approach towards building wealth. If so, why are there very few money managers who practice this approach? First reason is that value investing is contrarian in nature. It involves buying stocks that are unpopular and holding them for a long period of time. This is a risky strategy for a money manager whose performance is evaluated on a monthly basis.
Another reason why money managers shun the value investing approach is the herd instinct. In Wall Street, if you buy the latest fad which is being chased by your peers and if you lose money, no one will criticize you. However, since value stocks are shunned by the street, a value investor will be a loner and he will be blamed for going against the herd if things go wrong.
Chapter 21: Stick to your guns.
As businesses evolve and change the criteria for identifying value investing opportunities also change accordingly. Graham who was the pioneer in value investing used to look for companies selling at two thirds of the net current assets value.  When manufacturing industry became the key industry in the United States price to book value became the criteria of choice to identify value. Soon, as services industry became prominent with their low asset base and low book values,  price to book value became meaningless and investors shifted to earnings based model of valuation.  Then came the phenomenon of leveraged buyout and the appraisal methodology became one more weapon in the armory of the value investor. Even as criteria to identify value keeps changing with the times, basic principle of value investing remains as timeless as ever.  Invest in companies trading significantly lower than their intrinsic value and then wait for market to identify its intrinsic value.  It may take time and patience.  Sometimes market may go up significantly while your investment remain lacklustre. Sometimes you may sit on cash with no value opportunity available to invest in as the market has run up considerably.  It is at these times that one must not lose faith (in the approach)  and patience. If you have done the homework properly and identified value stocks, eventually  you will be rewarded handsomely.

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