INVESTING STRATEGIES The 5 Keys to Value Investing.

The 5 Keys to Value Investing.

http://www.amazon.co.uk/Five-Keys-Value-
Investing/dp/0071402314/ref=sr_1_12/202-7523631-
9877467?ie=UTF8&s=books&qid=1178998814&sr=1-12

Rationale of book:

1. You will have a specific value framework to help you make investment decisions.

2. You will know how to find the balance between price and value, and how to “buy
right.”

3. You will know how to identify events that move stock prices.

4. You will be able to generate your own value investment targets and build your own
portfolio.

Goal of the Value Investor:

Good Business + Excellent Price = Adequate Return over Time

Emotional Discipline:

With an established framework, value investors are more likely to avoid getting caught up with the moods of the market or their own emotional feelings of the day.

Characteristics of Value Investors:

1) They exude emotional discipline,

2) They possess a robust framework for making investment decisions,

3) They apply original research and independent thinking.

The Seven Fundamental Beliefs:

Belief No. 1: The world is not coming to an end, despite how the stock market
is reacting.

Belief No. 2: Investors will always be driven by fear and greed, and the overall
market and stocks will react accordingly. This volatility is simply
the cost of doing business.

Belief No. 3: Inflation is the only true enemy. Trying to predict economic variables
and the direction of the market or the economy is a waste of time—
focus on businesses and their values, and remember Belief #1.

Belief No. 4: Good ideas are hard to find, but there are always good ideas out
there, even in bear markets.he primary purpose of a publicly traded
company is to convert all of the company’s available resources into
shareholder value. As shareowners, your job is to make sure that this
happens.

Belief No. 6: Ninety percent of successful investing is buying right. Selling at the
optimal price is the hard part. As a result, value investors tend to
buy early and sell early. [Buying early allows the investor to use
dollar cost averaging. Dollar cost averaging is buying more shares of
a particular company as the share price trades lower in the market
place.]

Belief No. 7: Volatility is not risk; it is opportunity. Real risk is an and
permanent change in the intrinsic value of the company.

Five key questions in considering investment opportunities:

1. Is this a good business run by smart people?

This may include items such as quality of earnings, product lines, market sizes,
management teams, and the sustainability of competitive positioning within the industry.

2. What is this company worth?

Value investors perform fair value assessments that allow them to establish a range of
prices that would determine the fair value of the company, based on measures such as
normalized free cash flow, break-up, takeout, and/or asset values. Exit valuation
assessment provides a rational “fair value” target price, and indicates the upside
opportunity from the current stock price.

3. How attractive is the price for this company, and what should I pay for it?

Price assessment allows the individual to understand fully the price at which the stock market is currently valuing the company. In this analysis, the investor takes several factors into account by essentially answering the question: Why is the company afforded its current low valuation? For example, a company with an attractive valuation at first glance may not prove to be so appealing after a proper assessment of its accounting strategy or its competitive position relative to its peers.

4. How realistic is the most effective catalyst?

Catalyst identification and effectiveness bridges the gap between the current asking price and what value investors think the company is worth based on their exit valuation assessment. The key here lies in making sure that the catalyst identified to “unlock” value in the company is very likely to occur. Potential effective catalysts may include the breakup of the company, a divestiture, new management, or an ongoing internal catalyst,such as a company’s culture.

5. What is my margin of safety at my purchase price?

Buying shares with a margin of safety is essentially owning shares cheap enough that the price paid is heavily supported by the underlying economics of the business, asset values,and cash on the balance sheet. If a company’s stock trades below this “margin of safety” price level for a length of time, it would be reasonable to believe that the company is to be sold to a strategic or financial buyer, broken up, or liquidated to realize its true intrinsic value—thus making such shares safer to own.

Example Valuation Approach:

1. Sum-of-the-parts valuation (using three different multiples EV/EBITDA, EV/FCF, and
PE).

2. Historical valuation (using the same multiples to see how the market valued the
company historically).

3. Transaction deal basis (comparison with similar deals using EV to Cash Flow and EV
to Revenue).

Take an average to give an idea of Fair Value. The need is then to establish a Purchase Price at a discount to Fair Value and with a margin of safety. For example, 5.5 times Enterprise Value to pre-tax and interest cash flow could be used.

Analyzing Financial Statements:

1. Income Statement.
The income statement reports revenues and expenses incurred over a specific time period. The income statement is important because it provides value investors with information that allows them to gauge the prospects of a company’s future
earnings. Generally speaking, the more income noted, the stronger the earnings power.

2. Cash Flow Statement.
It provides: a) the sources of cash during a period, b) uses of cash during a period, and c) change in cash balance during a period.

There are three sections to the statement of cash flows:

i) Operating activities include the daily transactions involving the sale of
products, and the results from providing services to customers. This could
include the cash receipts from the sale of goods or services and the cash
payments to suppliers to purchase inventory.

ii) Investing activities include lending money, collecting on those loans, or buying
and selling assets.

iii) Financial activities include obtaining cash from creditors, repaying the
amounts, and providing them with dividends.

The most important, however, is the cash flow from operating activities, as it involves the sale of goods and services—the viability of the company. If it is clear that the cash flow from operations is not the primary source of cash, the company may be headed for trouble.

3. The Balance Sheet.
Essentially, the balance sheet summarizes what the company owns and compares it to what the company owes to outsiders and investors. The balance sheet always balances between assets and liabilities plus equity. The assets in a balance sheet are the economic resources that are expected to generate future benefits to the sheet provides the independent value investor with the tools with which to make sound judgments on the financial health of the company.

Three Approaches to Understanding the economics of a business:

1. Vertical Assessment Approach.
There are six specific tools the value investor uses for a
typical non-service-oriented company.
They include the 1) industry analysis, 2)competitive position analysis, 3) manufacturing, 4) operating, 5) tax strategy assessment,
and 6) debt analysis.

The use of a common-size statement is the most popular way of performing a vertical
analysis. A common-size statement is an income statement that shows all items as a
percentage of sales as well as in sterling form.

One of the industry tools that has been well received among investors is the industry
framework developed by Professor Michael E. Porter. What makes the Porter framework
particularly useful is that it is widely used among a variety of investors of different styles.
His framework assesses five different “forces” that drive industry profitability. The forces
include the threat of new entrants, the threat of substitute products, the bar-gaining power
of buyers, the bargaining power of suppliers, and the degree of rivalry among
competitors.

Operating cost control:
Assessing a company’s operating cost controls includes looking at the trend of expenses as a percent of sales over time.

A certain amount of debt on a company’s balance sheet is good, because it can prevent
management from making costly mistakes e.g. implementing a diworseification strategy.
Academics refer to this benefit as “the discipline of debt.” There is a “right” amount of debt that a company can have to avoid financial distress, operate under ample disciplinary constraints, and maximize its returns. When considering debt analysis of a company, the value investor uses two primary tools: Interest Cover and Debt-to-total-capitalization ratios.

2. ROE Decomposition Approach.
The ROE approach, better known as the “du Pont Model,” highlights how profitably management has been able to allocate the firm’s resources. Return on sales (ROS) indicates the amount of profits a company is able to keep for each dollar that the company takes in from the sale of goods and services. Asset turnover shows the amount of revenues the company is able to generate for each dollar of assets committed. Return on sales multiplied by asset turnover generates return on assets
(ROA).

ROS (Net Income/Sales) * Asset Turnover (Sales/Assets) * Financial Leverage
(Assets/Equity) = ROE.

Good businesses consistently produce ROEs greater than their equity cost of capital.

3. Cash-Flow-Based Approach.
There are three common definitions: net cash flows, cash flows from operating activities, and discounted cash flows. Net cash flows are calculated by taking a company’s net income and adding or subtracting non-cash items. This is sometimes referred to as cash earnings. The intent of net cash flow is to show the cash
that the company generates. This calculation is well liked among investors, with one
caveat, however. The problem is that it assumes that a business’s working capital accounts do not change over time. As a result of this failure, many investors look to cash flow from operating activities, which includes the change in assets and liabilities, as well as net cash flows. The final type of cash flow is the discounted cash flows method (DCF),which is the sum of future cash flows discounted to the present. DCF is used—among other reasons—because it takes into account the time value of money. The discounted cash flows method is generally used as a valuation tool, and less as a business “assessment” tool.

Business Quality red flags:

There are several key red flags that value investors look for when evaluating the earnings quality of a company. The following are the 15 common red flags; and, if identified,should warrant a closer look:

1. There is a difference between the company’s accounting policy with other
companies in the same industry such as how revenue is recognized. Check the
footnotes.

2. Management’s incentive package is purely based on increasing earnings per share
and has the discretion over accounting treatment.

3. There are unjustified changes in estimates, accounting, or financial policies.

4. There are special business arrangements and deal structures to achieve accounting
objectives, such as earnings growth.

5. The Letter to Shareholders does not adequately disclose the company’s business
strategy and its economic consequences. The Letter to Shareholders can be found
in the company’s annual report.

6. The management was not complete in addressing the prior year’s poor performance in
the MD&A. The Management’s Discussion and Analysis (MD&A) can be found in
the annual report.

7. There are changes in accounting. Look at the footnotes.

8. There are unexplained transactions that helped earnings. Scrutinize the footnotes
to uncover uncertainties.

9. There is an abnormally high increase in inventory relative to sales growth.
Review the latest income statement, as well as the balance sheet.

10. There is an abnormally high increase in accounts receivable relative to sales.
Take a look at the income statement and balance sheet.

11. Net income is growing faster than cash flow from operations. Take a look at the
most recent statements of cash flow and income.

12. There is an unexpected and large write-off or charge-off. See most recent news
on the company.

13. There is a large fourth-quarter adjustment. Take a look at the annual report.

14. The company is lending money to customers or has a significant equity stake in
its customers.

15. The company changes expense calculations or any other material items that can
enhance earnings. See the footnotes in the annual report.

Assessing management:

Buffett's advice is to read the annual reports of the company and compare them from one year to the next. Go back as far as possible to determine whether management lived up to the promises made. Buffett also suggests that investors compare a company’s annual reports to its competitors’ reports. Management credibility is extremely important. And the best way that managers can earn credibility over time is to deliver on their promises.Value investors typically assess past promises by reviewing management’s past letters to shareholders and analyzing the financial statements.

In analyzing the financial statements, some investors employ an economic value added
(EVA) approach to assign management’s ability to make decisions. EVA simply assesses
if current management was able to generate excess returns with the capital they invested above the cost of their capital. EVA is a company’s after-tax operating income minus its cost of capital. The formula is as follows: EVA = Net Operating Profit After taxes - (costof capital * capital employed).
Economic value added is appealing because it takes into account management’s ability to make prudent capital allocation decisions. Look to see if the company links its management incentive schemes to it.

Price and Value Assessments:

The objective in the game of investing is to buy low and sell high. To properly assess the price of a company’s stock, one has to be willing to uncover the necessary data points in order to understand fully the business and the value metrics that a rational buyer of the enterprise would be using in valuations.

Some investors spend time trying to estimate what the next three to four years will look like for a particular company. There are a variety of news services and research
companies that publish the future earnings predictions of analysts. Investment analysts use these estimates to value companies. Value-minded investors, on the other hand, focus not on earnings that are too distant; rather, they concentrate on what earnings and cash flows are today.

To get to a company’s fair value, the value investor triangulates a valuation.
Triangulation involves using three of the best valuation tools for that particular business.
There are three broad categories of tools that a value investor uses to value a company.
They are comparison based, asset based, and transaction based. In each of these
approaches, using “multiples” is the most common tool that investors use to value
companies.

There are different types of valuation tools. Some are comparison based, whereby the
value of the enterprise is based on the valuation of other similar companies. There is an asset-based valuation, which focuses on the intrinsic value of the enterprise. Transaction- based valuation tools assess the worth of a business based on what other companies have been sold for in the market place.

1) Comparison-based tools:
Comparison-based tools compare one company to anothercompany of similar likeness. In the comparison-based valuation toolbox, value investors possess many different valuation tools that they can call upon to determine the value of an
enterprise. The most common tools are price-to-earnings (P/E); price-to-book (P/B);
enterprise value to earnings before interest, tax depreciation and amortization
(EV/EBITDA); and price to sales (P/S) or enterprise value to revenues (EV/R).

a) Price-to-Earnings: The most common way to use P/E ratios is to find a few companies that are very similar to the particular company in question. These similar companies are often called comparable or “twin” companies. The objective is to get a relative sense of the value of the enterprise based on the current value of the company’s peers. Finding good twins may be a problem because no two companies are completely alike. They may have a different product mix, financial leverage, etc.

The relative P/E ratios are used to assess the P/E ratio of a company in relation to the market. One can compute relative P/E by taking the company’s current P/E and the
current P/E of the stock market. The relative P/E metric is used two different ways. Some use the firms’ relative P/E and compare it to the historical trends. For example, if a company’s stock has had historically a 10-percent discount to the overall market P/E, and now it is trading at a 25-percent discount, the stock would presumably be cheap. The other way that investors use this metric is to compute a relative P/E ratio as it relates to its sector-average P/E. One shortcoming with using the P/E ratio is that it cannot be used to value firms with negative earnings.

There are four primary concerns that relate to the use of earnings. First, the accounting used can have too much of an impact on earnings among similar firms. Another concern with using earnings is the fact that it excludes both business and financial risks. One may have too much leverage, and the other may not generate enough cash to finance its operations. The earnings number is not a “cash” number. This fact leads to the third concern: earnings exclude required investments to keep the business operating and growing. Investments such as capital investments are excluded in the earnings calculation. Capital expenditures are critical because significant outlays should be taken into account when assessing the economic value of an enterprise. While depreciation expenses are included in the earnings number, they are a noncash item; they thereby reduce the economic value of the enterprise. Value investors often add back depreciation and deduct capital expenditures as an ingredient to obtain a firm’s economic pulse.

The P/E ratio is best used among investors when evaluating financially sound companies with no near-term (in one to three years) capital expenditure requirements on the horizon.
The stock market on a long-term basis focuses on management’s impact on the cash flow
growth rather than pure accounting earnings.

b) Price-to-Book:
This valuation tool gives investors a sound measure of value, which can
be compared to the market value. Book value, net worth, and shareowners’ equity value
are essentially the same. P/B is also attractive to some investors because one can value companies with negative earnings—a feature that the well-liked P/E ratio fails to deliver.

The critical failing here is that P/B is useless if legitimate treatment of depreciation is different among firms in an industry. Therefore, investors using P/B without taking a very close look at items such as depreciation would be misled. The other critical failing is that as the economy becomes more technology and service oriented, the less P/B becomes valuable as a tool. Specifically, the tangible assets of companies in the technology and service sectors are insignificant. Ideas and human capital, while difficult to quantify, are much more important assets for these market sectors.

Companies with various amounts of options outstanding can be wrongly assessed as
being undervalued or overvalued. In some cases, companies with a great number of
options outstanding can appear to be undervalued, since the market value in the
numerator appears lower due to the unrealized level of options in the company. The value investor typically adds the market value of the options to the market value of the equity before calculating the P/B ratio. When comparing book values across firms, the value investor also takes into account stock buyback programs and recent acquisitions the company may have had, in order to assess it properly. When companies buy back their own stock, the book value of the equity declines by the amount of the repurchase. This is what happens when a company pays a cash dividend. In fact, some regard stock buybacks as just another form of a dividend. However, buybacks have historically been larger in dollar amount than dividends, and therefore have had a larger impact on a firm’s book equity.

A drop in ROE typically has an indirect, adverse impact on P/B ratios as the book value falls. Some investors believe that the strong relationship between ROE and price-to-book value gives some of the best clues to uncover undervalued companies. Companies with high ROE should trade at high price-to-book value multiples and vice versa. Companies in which value investors are most interested are those with a high ROE, and are valued in the marketplace with low P/B value ratios.

Some investors believe that the strong relationship between ROE and price-to-book value gives some of the best clues to uncover undervalued companies. Companies with high ROE should trade at high price-to-book value multiples and vice versa. Companies in which value investors are most interested are those with a high ROE, and are valued in the marketplace with low P/B value ratios. Said differently, the P/B ratio should increase if the spread between ROE and the cost of equity increases.

c) EV/EBITDA:
Value investors also try to gauge the intrinsic worth of a company by examining the entire firm—the company’s enterprise value. This is done by taking the company’s market value, adding its total debt, and then subtracting the cash. Including a
control premium, this is the value that a private or strategic buyer of the enterprise would pay for the company.

The treatment of cash is what often confuses new users of this tool. There are two simple reasons why cash is excluded. First, the value of a firm is the value of its equity and its debt. By taking out the cash, the formula is essentially using a “net” debt number—debt less the cash, or absolute debt. The other reason is more complex. Interest income is not included in the EBITDA number. Often, this interest income involves returns from idle cash. Therefore, since this interest income is not included in the EBITDA calculation in the denominator, then it should be taken out of the numerator as well.

This multiple can be used across a wide variety of firms with negative or depressed
earnings. Second, given the differences in depreciation among companies, EBITDA adds
back the depreciation to compare the operating-cash-generating strength of similar
companies.

EBITDA has many shortcomings and Buffett does not like it. With the proper perspective on the failings of EBITDA on hand, the investor can begin to apply the EV/EBITDA tool with the proper level of caution. The best way is to focus on three variables: tax rate,depreciation and amortization, and capital expenditures. Regarding the tax rate, value investors often regard companies with lower tax rates as companies who deserve a higher EV/EBITDA multiple, as opposed to those with higher tax rates. Likewise, they view companies who derive a greater portion of the EBITDA from depreciation and amortization as companies of a lesser quality and believe that these companies should warrant a lower multiple. Finally, the value investor focuses on capital expenditures and concludes that companies using a greater portion of EBITDA for capital expenditures deserve a lower multiple. In addition, that investment in capital expenditures has to generate a return above the company’s cost of capital.

d) EV/Revenue and Price/Sales:
Enterprise value to revenue is calculated by taking the firm value, which includes the firm’s debt and equity, and dividing it by revenues. The current equity market value, which is the stock price multiplied by the shares outstanding divided by the revenues, gives us the price-to-sales ratio, or P/S.

In the very rare occasion when value investors use revenue-based multiples, they prefer using EV/R because it values the entire firm. Price to sales values the equity portion of a company. In general, the reason why most daring investors like to use revenue multiples is that they are not influenced by accounting decisions that can plague other valuation tools such as the P/E or EV/EBITDA multiples. When using P/S, a company is seen as being undervalued despite the fact that it may have too much debt on its balance sheet.
Therefore, when comparing one company to another, P/S ignores the amount of debt a
company has on its balance sheet—which is an important element in determining firm
value.

The disadvantages of EV/R and P/S are their heavy emphasis on future top-line growth.
For example, investors often pay a high multiple for a company that is showing strong
sales growth despite the fact that it is losing money or going into lower-margin
businesses. If an investor decides to use EV/R or P/S, it is done in concert with an
assessment of the firm’s industry growth dynamics, the company’s competitive
positioning, and profit margins.

e) Other Enterprise Value metrics:
There is EV/EBIT, EV/EBITDA-Capital expenditures, and EV/Cash Flow. These multiplies have the same characteristics as EV/EBITDA, but with more variables included in the denominator like EBITDA-CAPEX, free cash flow, EBIT, with the exception of the EV/EBIT ratio, which does not add back depreciation. EV/EBIT is often used in industries where capital expenditures are typically for maintenance purposes and are close to depreciation and amortization expenses.

f) PEG Ratio: Most value investors do not use PEG ratios.

Some practitioners of PEG use forward-looking PE ratios. When investors use the PEG
ratio this way, they are double counting the growth of the company.

Several investors on Wall Street compare PEG ratios among industry groups. If a
company has a high ratio relative to the group, it is deemed overvalued, and vice versa. If two companies have the same growth rate with one paying out a large part of its earnings in the form of dividends, the dividend-paying company would have a more desirable growth characteristic than the one with 100% of earnings reinvested in the company. Comparing PEG ratios works only when companies have the same growth characteristic and risks associated with that growth. At a minimum, it should be used with other tools—and with extreme caution. The best way to use PEG—if at all—is to find the absolute perfect twin company with similar earnings risk, growth prospects and type, and retained earnings characteristics.

2) Asset-based Tools: Asset-based valuation tools are not based on the valuation of twin companies. They are based on the value that a particular company generates—its intrinsic value.

a) Discounted Cash Flows. Discounted cash flow becomes a very useful tool for valuing the assets of a firm. At its core, it values companies without using market price quotations, and incorporates the time value of money. The value of a firm is the discounted value of a company’s free cash flow.

Net Income + Depreciation + Amortization - Capital Expenditures = Free Cash Flow

Buffett uses the long-term Treasury rate as his discount rate. Other investors use a
weighted average cost of capital (WACC) as their discount rate because it is the overall expected return from the entire enterprise.

DCF does not work well in very common situations, such as when analyzing cyclical
companies, companies who are acquisitive, companies undergoing a corporate
restructuring, and companies with hidden or underutilized assets. For example, assets
such as idle but valuable land or unutilized licensing agreements would be valued at
nothing under DCF. Value investors use DCF when the cash flows of the enterprise are
not too cyclical, and it can be assumed that they will have relatively the same risk profile in the forecasted future of five to seven years.

b) Sum-of-the-parts: The sum-of-the-parts method is essential for carving the business in different parts, which may require different tools to evaluate each.

3) Transaction-based Tool: The transaction-based tool relies on the values that the acquired company places on a firm’s assets. The applications of the tools are less rigid, essentially using the same valuation metrics that buyers of business have used in the general market. These metrics can include EV/cash flow, P/S, DCF, etc. It all depends on the data that is available. The only requirement is that the value investor searches aggressively for prior transactions of similar businesses.

Catalyst Identification and Effectiveness

While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization f underlying value through a catalyst is an important means of generating profits. Furthermore, the presence of a catalyst serves to reduce risk.

Firm value catalysts include such business transactions as a company merger or
acquisition. There are a number of forces that help bring security prices into line with underlying value. Management prerogatives such as share issuance or repurchases,
subsidiary spin-offs, recapitalizations, and, as a last resort, liquidation or sale of the business all can serve to narrow the gap between price and value.
Internal catalysts:

New management can be installed.

The company can employ a new corporate strategy. Investors often look at a sales-to-
capital ratio as a tool to help analyze such revenue growth prospects. The investor
calculates this ratio by taking the sales figure, available on the income statement, and dividing by the firm’s capital, found on the balance sheet. A higher sales/capital ratio limits the need for the company to plow back cash to finance growth, thereby increasing cash flows and ultimately the value of the enterprise. Many investors often focus first on the impact that investment decisions have had on a company’s overall cost of capital, in order to gauge their potential returns. The objective is to identify capital that is being allocated to more profitable areas of the firm, which are not likely to increase the company’s cost of capital or the risk profile of the enterprise.

Companies can also implement new product strategies. Value investors watch for
potential catalysts that will reduce operating risk by making the company’s products and services stickier (i.e. drawing in repeat customers). Advertising is often a company’s method of choice to accomplish this goal.

Improved operational efficiencies can also be a catalyst. If a company can increase its operating margins relative to its peers, it can generate greater value for its shareholders.
Investors often target companies with low margins relative to their industry counterparts,because these companies will benefit most from this type of catalyst.

Cutting costs is one of management’s favorites. Often, companies reduce costs by cutting back on research and training, even though this may be sacrificing their future growth potential. Such cost cutting is not prudent, and will often be a detriment to the company in the long term. Cutting costs as a sole means to drive firm value can be a dangerous game.
In fact, cost cutting is often promised as a means to justify value-destroying decisions by management. Take acquisitions for example. Companies often overpay for companies and offer cost cutting opportunities to pacify shareholders. Unfortunately, rarely are such promises delivered.

Investors often view a new financial strategy as a potential catalyst. The value of a firm is often determined by the cash flows generated by the company, discounted back to the present at a cost of capital. Typically, a reduction in a company’s cost of capital will increase the value of a firm. To reduce a firm’s cost of capital, management will often change the levels of debt and equity on the balance sheet. Debt is much cheaper than equity, as the lender bears less risk than the equity holders. However, too much debt could cripple a company and push it into financial distress. As the cost of capital decreases, the value of the enterprise will only increase if the higher debt levels do not affect the cash flows of the firm. This is a delicate balance that value investors must assess carefully.

A sustained tax rate reduction can be a potent catalyst. There are certain initiatives that can be implemented to help reduce the tax burden. These include multinational companies moving income around to take advantage of optimal tax environments,acquiring operating losses from other companies so they can use them to shield future income, or using complex risk management procedures to reduce the company’s average tax rate. Value investors, in general, are skeptical of tax strategies to increase firm value. The non-cash working capital in a company
is the difference between the non-cash current assets and the non-debt portion of current liabilities. This typically includes inventory and accounts receivable less accounts payable. Any setbacks making improvements in working capital could affect the company’s future growth and operating income. This is due to the fact that companies often maintain inventory and provide credit to their customers as encouragement to buy more goods and services. When considering the potency level of working capital as a potential catalyst, the value investor assesses the potential risk that the company may lose sales in an attempt to reduce investments in working capital.

Reducing capital investments to create value is very tricky. The net capital investments made by companies—the difference between the company’s capital expenditures and depreciation—is cash coming out of the company that reduces the cash flow to the firm. This cash is typically used to fund future growth opportunities, while maintaining other assets in the company. While a company might generate cash inflows by reducing investments in existing assets, which can generate value for shareholders, it also risks reducing the life span of these assets. Conversely, if a company invests all of its capital on existing assets, there may be no free cash flow—a move that may impair firm value.

Share buybacks are one of investors’ favourite catalysts. It is when a company’s stock price trades at a significant discount to a firm’s fair value that value investors mostly search for catalysts. The most common catalyst, and certainly less complicated in terms of execution, is the stock repurchase.

There are six primary reasons why companies buy back their own stock: 1) to reduce the company’s dividend cash outflow without reducing the dividend itself; 2) to signal to the stock market that the company’s stock is undervalued; 3) to increase earnings per share;4) to change the company’s capital structure; 5) to buy the shares of a big seller of the stock; and 6) to give current shareholders a tax-friendly cash distribution.

Value investors view a buyback as an acquisition made by the company; the price has to be right. Increasing earnings per share is many times best achieved when the company uses new debt to finance the repurchase. This action increases not only earnings, but may also increase a firm’s ROE. Return on equity could increase due to the change in the firm’s capital structure.

Spin-offs and equity carve-outs can be a good way to spur a company’s share price. For example, a slow-growth, low-margin conglomerate that has a fast-growing, high-margin division, may be a good candidate for a spin-off, due to the potential valuation differences. In addition, companies with several divisions and complex structures are hard to value, and are often valued at a significant discount to the values of their parts.
Spinning off divisions is often a remedy that eliminates this conglomerate discount.

Split-offs. A split-off is similar to a spin-off. The difference is that in a split-off, investors must choose which company they would like to own, the parent or the new company, but not both. Value investors focus on the quality of the two businesses, their values, and the price at which these investors would own the shares—factoring in any incentive from the parent company.

Asset Sale: An asset sale is only part of the value creation. The other half is the use of the proceeds. Typically, if these assets generate investment returns less than the company’s cost of capital, or what they could potentially generate, then they are the most potential candidates for sale. The use of the cash received from the sale of assets can also be a catalyst. There are typically three uses for the cash received. First, the company can invest the cash in the stock market. Secondly, the company can invest the cash in other areas of the company, which might produce a higher return for the company. Finally, as a less risky alternative, the company might share the proceeds of the asset sale with shareholders by repurchasing stock or issuing a dividend.

Worth more dead than alive: full or partial liquidations are often a potent catalyst.
Liquidating would be a catalyst if the stock price of the company trades well below its liquidating value—a value that is computed as the net worth of tangible assets to the firm.

External Catalysts:

The presence of shareholder activists.

Industry merger activity can also be effective. A good acquisition target might be a firm that is doing a poor job managing its assets or one that has assets that are too complicated to be properly valued by the general market. For example, companies that have several business units often trade at a deep discount to their after-tax sum-of-the-parts valuation. Exploiting a target’s debt capacity, for example, is a viable reason for acquisition. An under-levered company with unused debt capacity is often a target because of the borrowing capabilities available to help finance the acquisition. Also, an increase in the debt capacity will help lower the combined company’s cost of capital, and in turn, will boost firm value. The value investor is particularly interested in the benefits relating to net operating loss carry forwards and the handling of depreciation. Both of these items have a positive impact on the cash flow of the buyer, since they can potentially lower
one’s tax rate. After-tax free cash flows increase, and obviously, so does the firm’s value.

Time: the silent external catalyst. The end of a temporary, negative catalyst—an adverse event or series of events, such as high resin costs for packaging companies or low oil prices for oil-related companies—can also prompt value enhancement.

The Margin of Safety Principle.

Graham's definition of margin of safety is essentially the gap between price and value. All else being equal, the wider the gap between the two, the greater the safety level. Graham also explains that the margin of safety is important because it can absorb mistakes in assessing the business or the fair value of the enterprise.

Some value investors use a variety of measures in determining a firm’s safety levels.
They are as keen on asset values as is on earnings and cash flow. Value investors look for several other different measures, such as break-up value, favorable dividend yield, and price-to-cash flow, as supporting casts to Graham’s margin of safety concept.

Graham sought to prevent excessive losses by buying companies at “net-net values”—a
price equal to the firm’s current assets less all liabilities, giving very little value to property, plant, and equipment. His focus was almost purely quantitative.

Quantitative:

Liquidation value: If the company in question operates in a declining industry, the
investor might use a liquidation value of the assets, given the fact that such assets would often prove to be of little or no use to others, especially if they are specific to a particular business. In calculating liquidation value, some value investors first calculate the asset value then subtract the liabilities. In calculating this number, some value investors take the value of cash and marketable securities. Marketable securities, assuming that they are short term, are valued at the face value at the time, which is essentially how the stock market values them. Then they would give a discount to other assets like plant, property
and equipment, and inventory. Depending on the industry and the usefulness of the asset,discounts can range from 20 percent on generic goods, which can be used in other industries, to 80 percent for highly specific goods that are useful to a particular industry. Such a high discount is essentially scrap value for such assets. Items such as goodwill and other intangibles are excluded in the valuation process.

Replacement value: If the company in question is in a normal and stable industry, the
value investor might choose to value the assets at replacement cost. The rationale is that if a competitor wanted to enter the industry, the suitor would either buy its way in or build its operations from the bottom up. Like the liquidation method, cash and marketable securities are taken at book value. After cash and these marketable securities, the value investor looks at a company’s receivables. The receivables on the balance sheet are the first area requiring an adjustment, as they include provisions should customers become delinquent. If a company entering the industry wanted to build a similar level of receivables, that company would most likely have to incur higher debts in order to reach similar levels to a firm already operating in that market. Value investors tend to look closely at the cost of inventory. There would be an increase in replacement costs in situations where the inventory on a company’s books had the benefit of lower raw material costs. Other items under current assets, like prepaid expenses and deferred taxes,
remain relatively at face value. Property, plant, and equipment (PP&E) are often the largest non-current assets on the balance sheet. The value investor assesses each part of the PP&E to arrive at the best replacement value. The “property” part of the PP&E is often stated below replacement value given the fact that property, such as land and real estate, typically appreciates in value over time. Moving on to goodwill, one can justify valuing it at zero, since it represents the mark-up for overpaid assets. The problem with tacking a zero value to goodwill is that it fails to give the complete picture of the financial environment. The fact that only tangible assets are calculated understates the value of an enterprise. As a back-of-the-envelope way for assessing goodwill, some value investors
often use a portion of goodwill, which can range from 10 percent to 60 percent of the
value reported on the balance sheet. This is then adjusted again for the degree to which this intangible asset contributes to the value of the firm. A company with strong brand value, allowing it to sustain a strong market position with increasingly loyal customers,could garner a higher value for its goodwill than a firm that has lesser characteristics. As a rule of thumb, some value investors take a critical look at a company’s debt, particularly if the financial strength is rated a B or less. It is critical to assess the past obligations,long-term debt, and ongoing obligations of the firm in question. These obligations are often listed under current liabilities and are due within one year. Value investors deduct
these liabilities from the replacement asset value to get the replacement value of net assets. Using the replacement value of net assets, the value investor deducts from this number the next two categories of liabilities: any past obligations, and long-term debt.

Interpreting the replacement value: Many value investors believe that if the asset value is greater than what the company is worth, then it can be assumed that it is a direct result of poor management or a bad industry. If the asset value is less than the intrinsic worth of the company, the magnitude of the difference sends an important message to investors. In this situation, value investors determine that there is considerable strength in the firm’s competitive advantage, or there exists a superior management team.

Book value assessment: Some investors rely on the book value of a company to gain
insight into what a company would be worth if it were liquidated. Adjustments may need to be made for goodwill and inflation e.g. undervalued property.

Qualitative:

“Take-private” valuation—a valuation based on what an investor reasonably thinks a
company could be worth in a privately negotiated transaction—is the valuation used for making a case for a firm’s safety levels. The rationale is that if a well-managed and sound publicly traded company trades at a price level that is attractive enough to another entity to raise capital to acquire the company, then that level is what investors can rely on as being the “floor” for the stock.

Getting something for free: A “sum-of-the-parts” valuation can be useful in determining the safety level in a stock price. Value investors often separate companies by division, notbecause the particular company is breaking up, but rather to determine whether the current price is offering one or more of the pieces of the business for “free.”

Dividend yield factor: Dividends can be a source of safety because of the yield generated for investors. A price decline would increase the yield to generous proportions. Investors,particularly those who are income conscious, would adjust the yield accordingly by purchasing the company’s shares. Dividend yields, while easily obtained, are seldom ever used as a sole factor in determining margin of safety levels of a given stock.

Historical perspective: Taking this historical perspective of companies could prove
beneficial to owners who are assessing what the buyers would be willing to pay for the enterprise. However, these types of exercises should be limited to those companies that are of a more cyclical nature in their business models.

Risk and Uncertainty:

Understanding risk and uncertainty is an important part of assessing a company’s margin of safety levels. It is important that investors know the difference between the two, how the difference can change or alter the way an opportunity is assessed, and the tools required to quantify properly the downside potential of any investment. The difference between the two is that risk is quantifiable and uncertainty is not. There are many different categories of risks and uncertainties. In simple terms, taking on risk occurs when an investor is not sure what might happen among a list of scenarios. Taking on uncertainty occurs when an investor does not know what can happen with an unknown range of possible outcomes.

Total Investment Risk = Basic Business Risk + General Market Risk

Value investors, in general, refuse to spend time predicting economic trends or
interpreting market sentiment. Time spent trying to predict the future is time not well spent. Focus on the basic business risk.
Business Opportunity:

Properly identifying the type of opportunity that is presented is critical to successful investing because the type of opportunity determines one’s approach and the analytical tools to consider. The opportunities are categorized in the following manner: modest/slow growth, high growth, event driven, cyclical, temporarily depressed, hybrids, and value traps.

Value traps are inexpensively priced companies that do not possess positive catalysts or that may operate in declining industries. Here are some of the more common examples of potential value traps:

Buying cheaply on valuation despite the fact that it may be a bad business

Buying a cyclical company with low valuation at the top of its cycle

Buying a stock solely because it has a low dollar value of say, $3 per share

Buying simply the cheapest company in an industry without understanding the economics
of the business.

Buying Right:

Be aware of the direction of interest rates and corporate profits, and be mindful of
inflation. Interest rates are one of the most critical factors that affect a firm’s valuation. In a 1999 Fortune article, Warren Buffet sums up the impact of interest rates to the general market best. “[Interest rates] act on financial valuations the way gravity acts on matter:
The higher the rate, the greater the downward pull.”

The Federal funds rate is the interest rate that banks must pay other banks for reserves. A higher rate means that banks will have fewer reserves and will lend less money. The lower the rate, the more reserve banks can have, which makes them able to lend more money for the economy to grow. Of course, this has an effect on the yield curve, which is a graph that shows the interest rate in relation to short-term and long-term bonds. The graph typically slopes upward to show that short-term rates are often lower than long-term rates, given the fact that lenders generally require higher rates for longer-term loans.
This “curve” inverts when short-term rates are higher or near equal to long-term rates,after the Fed raises rates to slow down the economy.
After-tax corporate profits are equally important. Value investors buy businesses as a form of investment, in order to recoup their investments plus additional sums of money in the future.

Inflation is monitored very closely by investors because of its powerful impact on real returns, and its ability to redistribute wealth between lenders and borrowers.

Value investors’ awareness of interest rates, corporate profits, and inflation help them buy right by getting a better understanding of the mood of Mr. Market.

Value investors use an analytical approach to the market. They think cyclically. Products have cycles, and so do industries, the economy, and the broader stock market.When employing the dollar cost averaging method, one invests a portion of one’s funds and buys more as the stock falls to attractive price levels. Dollar cost averaging is a very good method to ensure that one “buys right,” as most investors have the tendency to buy when stock prices are going up rather than down. Dollar cost averaging, with a price level not exceeded by the investor, helps investors control the urge to buy a stock on its way up. In order for dollar cost averaging to be financially worthwhile, one must assess the amount of funds available to invest, and then decide if it makes economic sense to handle the investment in this manner. While the commission fees charged for each transaction may differ, the investor must be keenly aware of the dollar amount required to make each transaction cost-effective before using this method.

Analyzing Earnings Announcements:

Step 1: Look at the trends in the numbers. Take a critical eye to the top line and
margins,and how they relate to management’s outlook for the company.
Calculate the percentage changes on a sequential basis, as well as for
year-over-year.

Step 2: Get behind the numbers by taking a closer look at each key line item in the
income statement and balance sheet, in order to assess what may be implied
for the next few quarters. Value investors look carefully to assess whether
or not the company has overstated revenues for the current quarter, as
companies try to account for as much revenues as possible before the end of
the quarter. An abnormally high or low operating expense number should be
examined to determine the source. Low operating expenses in a quarter yield
higher operating margins, and the reverse is true for high operating
expenses. Value investors consider recurring one-time events in companies’
reports red flags, as it may signify unstable business models. In addition
to restructuring charges,gains or losses associated with “accounting
changes,” “discontinued operations,” and “extraordinary items” should be
checked for accuracy. The next area of focus should be the net interest
expense line item. The vast majority of interest expense is from loans the
company has from banks (bank debt) and funds borrowed from the public
(bonds).
Abnormally low tax rates in a given quarter, compared to previous quarters,
should be investigated before arriving at net income or net earnings.
For the balance sheet,depending on the industry and the circumstance, the
focus is typically on the current assets and the company’s total debt.
Regarding the company’s debt, one typically assesses the company’s long-term
and short-term debt and notes payable to see if there are any unexplained
significant changes.

Step 3: Think about your reasons for purchasing the company and ask yourself whether
or not anything has changed.

Selling:

Subsequent selling occurs when the following arises:

1. My ongoing research reveals deterioration of the business fundamentals or
permanent impairment to the assets of the firm.

2. The company reaches its fair value.

3. The catalyst that I identified prior to making the investment is unlikely to
materialize,or is proven ineffective.

Screening for ideas: A blueprint:

Good business: Search for companies with high ROEs, earnings quality and growth, free
cash flow, sustainable competitive advantages, and outstanding management.

Cheap price: Depending on the industry, search for companies with price-to-earnings
ratio less than 15, price to sales less than 1.5, at or near private
market valuations, and at least 40-percent discount to fair value.

Obtainable value: Search for companies off 50 percent or more from 52-week highs in
bull markets, and off 60 percent of highs in bear and sideway
markets; cyclical companies; and industry leaders in commodity and
low-tech industries.

Candidate for catalysts: Search for companies with extremely low margins in high-
margin industries; companies trading at, near, or below net
cash on their balance sheets;and companies trading below
net asset value or private market values.

Margin of safety: Search for companies with pristine balance sheets, with no or very
little debt compared to other industry players, tangible book
values, and companies trading near take-out or liquidation values.
The specific approach that non-professional investors should take
in building their own portfolios is the following:

1. Prepare mentally and emotionally for the volatility in performance.

2. Use the Five Keys of Value framework in a highly disciplined manner.

3. Own between 10 and 20 but preferably 15 good businesses at excellent prices.

4. Allocate wisely—invest more in the companies you like best.