On Value Investing
Warren Buffett once said: “Be Greedy when others are fearful and Fearful when others are greedy”. As much as this may sound philosophical, it is a good starting point for value investing. Value investors will buy undervalued, unpopular stocks and sell when others recognize the value of the company.
There are different kinds of value investors, each with his own tailored approach. But the core philosophy is the same.
1- Do not lose money
2- Have a margin of safety
3- Be patient
You may think this is what every investor’s philosophy should be like but it’s easier said than done. I’ll later give an example and show how a value investor protects himself. But let’s first talk about value investing.
Value investors seek to purchase a security at a bargain price. Surely then, valuation plays an important role in this process. It is agreed that the value of a company is the future value of its cash flows discounted back to the present. This valuation technique depends on assumptions about future cash flow which most of the time is impossible to get right. It also assumes growth in the future has value. When in reality, the only growth that has value is the growth that produces returns that exceed the cost of additional capital. For companies need to pay for additional capital to fund growth.
So how do we find these companies? Usually they are companies with a competitive advantage. Either a very strong brand, some regulation that gives them an edge or strong barriers to entry in the industry… A value investor’s job is to find these companies and wait for an opportune price.
Now let us do a quick exercise of valuation. We’ll take a simple balance sheet and try to determine a conservative price. This price will be our entry point into the stock.
I chose Blackberry as its balance sheet is straightforward. As discussed above, we won’t use a cash flow model because BB will probably not exist in 10 years in its current form and it is therefore impossible to forecast their cash flow.
The image below shows Blackberry’s balance sheet as of the last quarter. We’ll use a variable of the net-nets method initiated by Ben Graham the father of Value investing to find a conservative price to the firm.
Meaning, in case the company goes on sale, we need to find a minimum price we feel comfortable with. Any price under this and we would definitely purchase the stock for our own portfolio. An important assumption in this case is that BB is self-sustainable and will not need to issue any debt or equity in the future.
The method is to discount the assets to more conservative value and calculate the book value from there. As BB is a technology company, I assume their inventory will be worth nothing should they have to sell it. I also place a null value on other current assets, assets held for sale and long term investments. More importantly I discount the price of their Properties and Intangible Assets by 80%, which in my mind is very conservative.
Finally after subtracting total liabilities from my adjusted assets and dividing by shares outstanding I get to $6.2. This is a conservative price and it means that BB is worth at least $6.2 should it get acquired. It also means that if, for whatever reason, the price goes to $5, it will not stay there for long as people will realize this is very cheap and will buy it.
Usually, a value investor will invest when the price is lower than $6.2. This way he’ll have his margin of safety and minimize the chances of losing money. He’ll then wait for the market to realize the real value of the firm and sell as the price goes up.
Depending on what value you give to PPE and Intangible Assets you get a range of Book Values. Using 50% of PPE and Intangibles will get you a price of $9.7.
Currently the market price is around $8.8, a 40% premium to our conservative estimate.
Always remember the first rule of Value Investing! Never lose money!