My notes on Seth Klarman's Margin of Safety - Part 2
Unlocking Potential is a newsletter by me, Francisco H. de Mello, CEO of Qulture.Rocks (YC W18)
|Francisco Souza Homem de Mello||Aug 16, 2020||8|
I'm surprised by the amount of - positive - feedback I got for my notes. I'm happy to have added value to your week. Here's the second chunk of my notes, following the second part of the book. It's very meaty :)
If you haven't already, subscribe and get new posts on your inbox. I only write when I have something I believe is good to say.
Enjoy the post.
Part Two: A Value-Investment Philosophy
The second part of the book, called “A Value-Investment Philosophy” is about the backbone of value investing, risk aversion, from which the need of investing with a sizeable margin of safety arises. He then goes on to discuss various valuation methods, under the objective of finding out how to be the most conservative investor possible, therefore only entering positions where risks are mitigated by a big enough margin of safety.
Kiko's notes on notes: a) The author always connects value investment with an hyphen, as in "value-investment" in the chapter title
Chapter 5: Defining your Investment Goals
The fifth chapter of the book is the first of its second part, entitled "A Value-Investment Philosophy." It starts with a quote from Warren Buffet that sums up the chapter's central idea, and the cornerstone of what Klarman understands as value investing. Buffet states that the first rule of investing is "don't lose money." The second rule, he says, is "never forget the first rule." The chapter is an introduction to the concept of margin of safety: investing in stocks at sufficiently high discounts to intrinsic value, so as to provide investors with a sizeable margin of safety for losses (the less you pay for an investment, relative to its worth, the less room there is to lose money.)
Minimizing losses seems perfectly logical. Nonetheless, investors often lose sight of risk management. Why? "While no one wishes to incur losses ... it can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest "hot" initial public offering." And yet, "the avoidance of loss is the surest way to ensure a profitable outcome."
Klarman then goes on to provide readers with a quantitative example of the power of compound returns - Warren Buffet's snowball -, which are extremely appealing for those making investment decisions, but that are ultimately a two-sided matter: losses – even infrequent ones – can permanently harm long-term results:
Compound Value of $1,000 Invested at Different Rates of Returns and for Varying Durations
Source: Seth A. Klarman
Klarman’s point: risk minimization is very interesting quantitatively. "A corollary to the importance of compounding is that it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal. An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year."
But albeit worse off, in the long run, the investor who maximizes shorter-term returns and overlooks risk may be socially and economically compelled to do so by a number of dark forces surrounding him. "There is an understandable, albeit uneconomic, appeal to the latter pattern of returns, however. The second investor will outperform the former nine years out of ten, gaining considerable psychic income from this apparently superior performance. If both investors are money management professionals," he links neatly into the third chapter, "the latter may also have a happier clientele (90 percent of the time, they will be doing better) and thus a more successful company." This is a very powerful conclusion, that may explain why Warren Buffet chose to run a permanently funded corporation in place of a regularly-chosen investment fund, where investor mood swings – and subsequent withdrawals – can put the business in jeopardy.
Kiko's notes on notes: It is important to note that Warren Buffet’s Berkshire Hathaway stock is very susceptible to investor mood swings. But if on one hand their sentiment can cause price fluctuations, on the other it can’t change the amount of money been run by the company, or force managers to change their course of action.
In order to maximize performance in the long-run, as proper investors, Klarman suggests that "investors intent on avenging loss consequently must position themselves to survive and even prosper under any circumstances." Bad luck can befall on them, and mistakes can happen since the "world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality."
Klarman concludes that minimizing risk is a matter of buying stocks at the right price. "The risk of loss stemming from equity's place in the capital structure is exacerbated by paying a higher price." Exacerbated, he means, because equities are riskier than bonds and cash: "being junior in a company's capital structure and lacking contractual cash flows and maturity dates, equities are inherently riskier than debt instruments."
Key Ideas from Chapter 5
1. Losses can asymmetrically affect investment performance. Investors should focus their efforts on minimizing losses first, then maximizing profits second
2. Doing that is a matter of buying stocks at the right price: at the largest possible discount relative to intrinsic value. That discount is a buffer against losses, and what value investors refer to as the margin of safety
Chapter 6: Value Investing - The Importance of a Margin of Safety
"Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is key to the process. In the language of value investors, this is referred to as buying a dollar for fifty cents. Value investing combines the conservative analysis of underlying value with the requisite discipline and patience to buy only when a sufficient discount from that value is available." That is a superb definition of value investing, with which Seth Klarman starts the sixth chapter of Margin of Safety.
Value investing sounds simple but is a very difficult framework to stick to. It may be very hard to find proper investment opportunities. Especially in bull markets, when prices and valuations tend to rise indiscriminately, investors may need to stay on the sidelines for long stretches of time if no opportunities arise. "When attractive opportunities are scarce ... investors must exhibit great self-discipline in order to maintain the integrity of the valuation process and limit the price paid." It also frequently means being a contrarian, challenging groupthink, and not making money when everybody around you seems to be profiting handsomely. "Yet over the long run the value approach works so successfully that few if any, advocates of the philosophy ever abandon it."
The merits of value investing, as Klarman says, are blurred in bull markets, but stand out in bear markets: "When the overall market is strong, the rising tide lifts most ships. Profitable investments are easy to come by, mistakes are not costly, and high risks seem to pay off, making them seem reasonable in retrospect.” As Warren Buffet is credited with saying, "you can't tell who's swimming naked until the tide goes out."
Klarman then delves deeper into the concept of margin of safety, and the many pitfalls that may get in investors’ ways.
First of all, it is analytically difficult to find bargains: "It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Not only may questions remain unanswered; all the right questions may not even have been asked. Even if the present could somehow be perfectly understood, most investments are dependent on outcomes that cannot be accurately foreseen."
In order to assess the merits of an opportunity, investors must look for value. Value can come from tangible assets (real estate, inventory, equipment) and intangible assets (brands and intellectual property.) Klarman prefers tangible assets, which "are more precisely valued and therefore provide investors with greater protection from loss. Tangible assets usually have value in alternate uses, thereby providing a margin of safety. If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated." But intangible assets are also important: "Some highly successful investors, including Buffet, have come increasingly to recognize the value of intangible assets - broadcast licenses or soft-drink formulas, for example - which have a history of growing in value without any investment being required to maintain them. Virtually all cash flow generated is free cash flow."
Kiko's notes on notes: Buffet is know for his investments in Coca-Cola, Gillette and Heinz.
So it is difficult to find and measure value, but it is also difficult to know if the value will stick around. The investor should look out for factors that may negatively impact value. Economic cycles, which may affect the availability of credit in the economy (and consecutively asset prices and multiples;) the existence of inflationary or deflationary trends; and political cycles, that may boost economic growth via government spending and investment. In deflationary environments, Klarman notes, investors must be even more conservative on value assessments, require a greater discount on stocks, and prefer shorter-term investments - those with foreseeable value catalysts - over longer-term ones, more sensitive to general price declines.
After analytical challenges are accounted for, and investors accept the fact that they will have only a quantitative approximation of true value, comes the question of what size of a margin of safety is enough. As Klarman says, "it comes down to how much you can afford to lose." The greater the margin of safety, the smaller the risk incurred. "If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot." Investors can only be certain of achieving a margin of safety "by always buying at a significant discount to underlying business value, and giving preference to tangible over intangible assets."
After finding out whether there is value in a stock, investors should strive to understand why it is so. Here, Klarman offers us a glimpse into the meat of the book: what he looks for - on top of value - in his stock holdings: "It is critical to know why you have made an investment and to sell when the reason for owning it no longer applies. Look for investments with catalysts that may assist directly in the realization of underlying value. Give preference to companies having good management with a personal financial stake in the business. Finally, diversify your holdings and hedge when it is financially attractive to do so."
Key Ideas from Chapter 6
1. Discipline is the name of the game.
2. Investors will be tempted to invest without a margin of safety in bull markets when everybody seems to be making easy money
3. Investors will be tempted to invest prematurely in bear markets when opportunities become increasingly abundant
4. Assessing value is very difficult, and several unforeseeable factors may influence value. The only way to overcome this is by aiming for the largest possible margin of safety
5. In assessing value, investors must look for tangible assets in the first place. Intangible assets may also hold value, but must be taken with more caution
6. After finding whether there is value in a company, the next challenge is understanding why there is value
Chapter 7: At the Root of a Value-Investment Philosophy
After explaining the concept of margin of safety, and the importance of proper risk management at the center of value investing, Klarman devotes chapter 7 to cover the other aspects of his value investing framework. According to the chapter’s introduction, "there are three central elements to a value-investment philosophy:
1 "Value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities".
2 "Value investing is absolute performance-oriented, as opposed to relative performance-oriented.
3 "Value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return)".
Kiko's notes on notes: Here, Klarman starts using "risk" as a synonym to "risk of loss," which is a bit different of what risk means in financial theory. In the textbooks, risk is measured as the volatility of a security, or it's shakiness, both upwards and downwards. Klarman will discuss why he thinks his use of the term is better
Bottom-up investing means that stocks are selected for their individual merit, regardless of being part of a trendy sector, or being potentially influenced by some perceived macro-economic trend underway. In Klarman’s words, bottom-up investing is a framework "by which individual investment opportunities are identified one at a time through fundamental analysis. Value investors search for bargains security by security, analyzing each situation on its own merits. An investor's top-down views are considered only insofar as they affect the valuation of securities." A great way to understand what bottom-up means is to compare it to its nemesis, top-down investing, which starts at the macro level, and then unfolds down to find specific securities that may best translate the macro-trend being traded upon. In his words, it means "making a prediction about the future, ascertaining its investment implications, and then acting upon them," an approach he suggests is "difficult and risky."
He gives us a hypothetical example: "a top-down investor must be correct on the big picture (e.g. Are we entering an unprecedented era of world peace and stability?), correct in drawing conclusions from that (e.g., is German reunification bullish or bearish for German interest rates and the value of the Deutsche mark?), correct in applying those conclusions to attractive areas of investment (e.g., buy German bonds, buy the stocks of U.S. Companies with multinational presence), correct in the specific securities purchased (e.g., buy the ten-year German government bond, buy Coca-Cola), and, finally, be early in buying these securities." So there are too many chained-predictions to get right, too many weak links that may rupture. "It is not clear whether to-down investing is a greater fool game, in which you win only when someone else overpays, or a greater-genius game, winnable at best only by those few who regularly possess superior insight. In either case, it is not an attractive game for risk-averse investors." Bottom-up investing, by contrast, is not acting "based on a concept, theme, or trend," but on quantifiable value.
Another interesting difference between top-down and bottom-up investors is the reason why each group may, at times, hold cash in their portfolios. Top-down investors may use cash balances to time and trade the markets, holding more cash when they think prices are going down, and less when they think markets are going up. Bottom-up investors, by contrast, hold cash whenever there aren’t enough interesting investment ideas fully form a diversified portfolio. There is no intention whatsoever of using cash to time the markets.
Another important limitation Klarman identifies in top-down investing is that its investors cannot easily assess when their hypotheses have been proved wrong. There are just too many variables at play, with compounded effects. Bottom-up investors, he argues, "can easily determine when the original reason for making an investment ceases to be valid. When the underlying value changes, when management reveals itself to be incompetent or corrupt, or when the price appreciates to more fully reflect underlying business value". In those cases, the investor can reevaluate his thesis, and act upon it. He adds that "in investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it."
Absolute Performance Orientation
The merits of absolute performance can be neatly summarized by this quote from Klarman: "for most investors, absolute returns are the only ones that really matter; you cannot, after all, spend relative performance." Absolute performance means buying low and selling high and thus making cash profits in the process. Relative performance means outperforming a benchmark, which could mean stay neutral when the benchmark goes down, or even lose less than the benchmark.
Klarman discusses aspects of this tenet in many chapters of the book. When institutional money managers are concerned with not breaking from the pack (at least negatively) they’re being relative-performance-oriented. When investors remain fully invested at all times, for being afraid of missing in on big market movements, they’re doing it again.
Sensible value investors only put money to work when there are compelling opportunities to make money. They may stay on the sidelines for a long-time, be criticized and compared to peers for their lackluster performance in bull markets, and even lose customer business in the process, but they must keep their cool and stay focused on the framework to achieve long-term, sustainable, and superior, investment performance.
Each opportunity must stand on its own merits, and be individually analyzed. In contrast, top-down investors, like most institutional money managers, need to beat stock market indexes and therefore may invest money whenever they think a stock may outperform its peers or the index, regardless of its value merits. This argument ducktails into the arguments of why top-down and bottom-up investors hold cash for different reasons: Bottom-up investors hold cash whenever they haven't found interesting ideas (bargains, or value-rich opportunities) to compose a diversified portfolio with, not paying attention to broad market directions.
His comparison continues: "short-term relative performance is commonly sought either by imitating what others are doing or by attempting to outguess what others will do. Value investors, by contrast, are absolute performance-oriented; they are interested in returns only insofar as they relate to the achievement of their own investment goals, not how they compare with the way the overall market or other investors are faring."
"While most investors are preoccupied with how much money they can make and not at all with how much they may lose, value investors focus on risk as well as return. To the extent that most investors think about risk at all, they seem confused about it. Some insist that risk and return are always positively correlated; the greater the risk, the greater the return. This is, in fact, a basic tenet of the capital-asset pricing model thought in nearly all business schools, yet it is not always true. Others mistakenly equate risk with volatility, emphasizing the "risk" of security price fluctuations while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments."
In this section, Klarman makes three main arguments:
A. In value investing, risk should be understood as "risk of loss," which is necessarily derived from deteriorating business fundamentals, and not from price fluctuations. Risk and return are not always correlated. "The risk of an investment is described by both the probability and the potential amount of loss. The risk of an investment - the probability of an adverse outcome - is partly inherent in its very nature."
B. Risks can't be known in advance, and thus the only way to manage risk is to invest with a margin of safety. "The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made." According to Klarman, there are three tools an investor can use to minimize the risk of loss: diversify holdings, hedge, when appropriate and possible, and finally invest with the largest possible margin of safety.
C. Financial theory's definition of risk (or beta) is limited for two reasons: it's backward-looking, and thus has little predicting power, and it's based on the efficient market hypothesis, that all information is already incorporated into market prices. Value investors don't believe in that - if they did, there would be no opportunities for them -. "In inefficient markets, it is possible to find investments offering high returns with low risk. These arise when information is not widely available, when an investment is particularly complicated to analyze, or when investors buy and sell for reasons unrelated to value."
Investors should also note that price fluctuations are inherent to investing, and therefore should be exploited: when investors see a compelling stock going down (and no facts have changed,) they can use the volatility to add to their positions. Alternatively, if a stock rises beyond what the investors believe is its fair worth, he or she must sell the position and take profits. Finally, investors should acknowledge that markets will fluctuate, so as to never be forced into selling for an external, unrelated reason, like needing cash for another business or obligation. That’s why a stock portfolio should be long-term savings, not used for short-term needs: "The trick of successful investors is to sell when they want to, not when they have to."
Key Ideas from Chapter 7
1. The primary goal of value investors is to avoid losing money
2. "There are three central elements to a value-investment philosophy:
2.1. "Value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities"
2.2 "Value investing is absolute performance-oriented, as opposed to relative performance-oriented
2.3 "Value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return)"
3. "Paying careful attention to risk - the probability and amount of loss due to permanent value impairments - will help investors avoid losing money
4. Holding cash and cash-generating securities enable investors to add to positions when markets go down and opportunities become even more compelling
Chapter 8: The Art of Business Valuation
The eighth chapter of Margin of Safety is a discussion about how value investors should work with the many valuation methods available since each and every one of them has important pros and cons.
Klarman believes that contrary to what some investors may believe - or even desire – investment valuation is an art and not a precise science: "Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined" because companies are just too complex, and the future just too unpredictable. "You cannot appraise the value of your home to the nearest thousand dollars. Why would it be any easier to place a value on vast and complex businesses?"
Kiko's notes on notes: Here Klarman works with the informal, crude depictions of “art” as something imprecise and subjective to the eyes of the practitioner, and “science” as something precise, just as two and two equals four. We all know science can be very blurry and imprecise as well, but Klarman’s use is helpful in setting the tone of the discussion.
With these ideas in hand, Klarman proposes that investors need to stop trying to achieve precision ("any attempt to value businesses with precision will yield values that are precisely inaccurate") and instead work with ranges. In order to reach meaningful conclusions about a company's - and thus a stock's – true worth, investors must use, and draw their conclusions, with a number of different valuation methods and an array of business assumptions, that yield a range of valuation figures.
"Benjamin Graham knew how hard it is to pinpoint the value of businesses and this of equity securities that represent fractional ownership of those businesses. In Security Analysis he and David Dodd discussed the concept of a range of value:
'The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate - e.g., to protect a bond or to justify a stock purchase - or else that the value is considerably higher or considerably lower than the market price. For such purposes, an indefinite and approximate measure of the intrinsic value may be sufficient.”
The three valuation methods proposed by Klarman are:
NPV, or Net Present Value: "NPV is the discounted value of all future cash flows that a business is expected to generate." Here Klarman also adds a subcategory of private-market valuation, which would be "an investor's assessment of the price that a sophisticated businessperson would be willing to pay for a business" in a private transaction.
Liquidation Value: "the expected proceeds if a company were to be dismantled and the assets sold off." Here Klarman also adds a subcategory of breakup valuation, which "considers each of the components of a business at its highest valuation, whether as part of a going concern or not."
Stock Market Value: "an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market."
Kiko's notes on notes:
I myself think a much neater breakdown of valuation methods would be:
i. NPV (or DCF - Discounted Cash Flows)
ii. Liquidation value (and breakup value)
iii. Comparables' analysis (both with public and private peers).
But, since this is Klarman's book, I am repeating his proposed categories
NPV is a very good method of valuation when (i) cash flows are predictable, and (ii) choosing an appropriate discount rate is possible. That is rarely the case in corporate finance and its lots of moving parts. The problem with using NPV in the equities space, according to the author, is that "cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present-value analysis an imprecise and difficult task." Even in the case of more predictable businesses, "estimating future cash flows ... is usually a guessing game."The author also believes that investors tend to be overly optimistic when forecasting financials: "Investors are often overly optimistic in their assessment of the future. A good example of this is the common responses to corporate write-offs. This accounting practice enables a company at its sole discretion to clean house, instantaneously ridding itself of underperforming assets, uncollectible receivables, bad loans, and the costs incurred in any corporate restructuring accompanying the write-off. Typically such moves are enthusiastically greeted by Wall Street analysts and investors alike; post-write-off the company generally reports a higher return on equity and better profit margins. Such improved results are then projected into the future, justifying a higher stock market valuation. Investors, however, should not so generously allow the slate to be wiped clean. When historical mistakes are erased, it is too easy to view the past as error-free. It is only a small additional step to project this error-free past forward into the future, making the improbable forecast that no currently profitable operation will go sour and that no poor investments will ever again be made."
Kiko's notes on notes: Klarman cites an interesting example: "Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game. A recurring theme in this book is that the future is not predictable, except within fairly wide boundaries. Will Coca-Cola sell soda next year? Of course. Will it sell more than this year? Pretty definitely, since it has done so every year since 1980. How much more is not so clear. How much the company will earn from selling it is even less clear; factors such as pricing, the sensitivity of demand to changes in price, competitors' actions, and changes in corporate tax rates all may affect profitability. Forecasting sales or profits many years into the future is considerably more imprecise, and a great many factors can derail any business forecast."
The final problem with an NPV analysis is choosing the right discount rate. Too often, small changes in the discount rate can produce very different analytical outcomes in an NPV calculation, and when it is so, investors should refrain from relying heavily on the method: "if modest changes in assumptions cause a substantial change in net present value, investors would be prudent to exercise caution in employing this method of valuation." Finally, it is of the utmost importance to calculate NPVs for a range of different discount rates, and then attribute probabilities to the different scenarios, in order for the investor to extract a range of possible values for the company.
Private Market Value
In this method, investors look for valuation parameters (usually multiples of price-to-book value, price-to-earnings, or enterprise value-to-EBITDA) in private transactions that have happened in the recent past with similar companies to the ones under study. The premise is that prices practiced by private equity firms and strategic buyers are professional, fair estimates.
Klarman is skeptical for various reasons: (i) not all companies are similar, even within the same sectors; (ii) valuation multiples are cyclical, thus varying over time, and (iii) strategic and financial buyers are not necessarily reasonable at pricing their deals.
Kiko's notes on notes: Within a given business or industry all companies are not the same, but private-market value fails to distinguish among them. Moreover, the multiples paid to acquire businesses vary over time; valuations may have changed since the most recent similar transaction. Finally, buyers of businesses do not necessarily pay reasonable, intelligent prices."
This is probably the most useful valuation method available to value investors, prefer to err on the conservative side. A liquidation value analysis basically tries to understand how much the company's assets would be worth if investors would shut it down and sell all the parts to the highest bidders. One could be more aggressive, adopting a fire-sale strategy, and of course, minimizing value, or adopting a more gradual strategy, selling the assets at a reasonable timing, and waiting for current business concerns (contracts, projects) to terminate. In any way, the important task for the investor is understanding how liquid are the company's various assets, or how easily one would find interested buyers to them. "Some machines and facilities are multipurpose and widely owned; others may have value only to the present owner. The value of restaurant equipment, for example, is more readily determinable than the value of an aging steel mill."
Kiko's notes on notes: If an investor were to analyze the liquidation value of Boeing, it would make sense to adopt a gradual liquidation strategy, and think of the company finishing off the airplanes under construction, so that it could sell them whole, instead of selling them as incomplete inventory. That's the idea of a gradual liquidation
Companies trading at or below liquidation value are understood to be usually trading at a bargain, because liquidation value tends to be the worst-case scenario, or ar Klarman puts it, a "rock-bottom appraisal." That is because "the assets of a company are typically worth more as part of a going concern than in liquidation."
Specifically, the author gives us an interesting glimpse at his rationale: "When no crisis is at hand, liquidation proceeds are usually maximized through a more orderly winding up of a business. In an orderly liquidation, the values realized from disposing of current assets will more closely approximate stated book value. Cash, as in any liquidation analysis, is worth one hundred cents on the dollar. Investment securities should be valued at market prices, less estimated transaction costs in selling them. Accounts receivable are appraised at close to their face amount. The realizable value of inventories — tens of thousands of programmed computer diskettes, hundreds of thousands of purple sneakers, or millions of sticks of chewing gum — is not so easily determinable and may well be less than book value. The discount depends on whether the inventories consist of finished goods, work in process, or raw materials, and whether or not there is the risk of technological or fashion obsolescence. The value of the inventory in a supermarket does not fluctuate much, but the value of a warehouse full of computers certainly may. Obviously, a liquidation sale would yield less for inventory than would an orderly sale to regular customers."
Net-net working capital (a type of liquidation value analysis)
This is a technique introduced by Graham and Dodd in their Security Analysis, which is thoroughly explained by Seth Klarman: "In approximating the liquidation value of a company, some value investors, emulating Benjamin Graham, calculate ’net-net working capital’ as a shortcut. Net working capital consists of current assets (cash, marketable securities, receivables, and inventories) less current liabilities (accounts, notes, and taxes payable within one year.) Net-net working capital is defined as net working capital minus all long-term liabilities. Even when a company has little ongoing business value, investors who buy at a price below net-net working capital are protected by the approximate liquidation value of current assets alone. As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all its liabilities, and still distribute proceeds in excess of the market price to investors. Ongoing business losses can, however, quickly erode net-net working capital. Investors must therefore always consider the state of a company's current operations before buying. Investors should also consider any off-balance sheet or contingent liabilities, such as underfunded pension plans, as well as any liabilities that might be incurred in the course of an actual liquidation, such as plant closing and environmental laws."
Stock Market Value
Klarman believes this method is of very limited use, because the markets, as he's put repeatedly, are not a reliable source of information about the value of securities. If it were, it's worth mentioning, it could be deemed "efficient," and investors' careers would be doomed. But there are occasions when using the market as a proxy for value can be useful. One first case is when the timing is of the essence; if investors need a rock-bottom appraisal in case of a fire-sale of assets, selling in the market is a good way to obtain immediate liquidity: "While the stock market's vote, especially over the long run, is not necessarily accurate, it does provide an approximate near-term appraisal of value."
How to choose among all the valuation methods? I have chosen to reproduce this short passage in its entirety because it is - short - and very neatly explained:
"How should investors choose among these several valuation methods? When is one clearly preferable to the others? When one method yields very different values from the others, which should be trusted?
At times a particular method may stand out as the most appropriate. The net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low. Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis. Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value. A closed-end fund or other company that owns only marketable securities should be valued by the stock market method; no other makes sense.
Often several valuation methods should be employed simultaneously. To value a complex entity such as a conglomerate operating several distinct businesses, for example, some portion of the assets might be best valued using one method and the rest with another. Frequently investors will want to use several methods to value a single business in order to obtain a range of values. In this case, investors should err on the side of conservatism, adopting lower values over higher ones unless there is a strong reason to do otherwise. True, conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizeable losses that would ensue from adopting less conservative business valuations."
There is a small section about the impact of the theory of reflexivity, by George Soros, on company fundamentals and a case study of Esco Electronics, a military electronics contractor. The theory of reflexivity, in short, discusses how the perception of the markets, translated as price action, may influence the fundamentals of a company. One obvious example is when a highly regarded company, albeit with poor fundamentals, is able to raise follow-on capital at a great premium, in fact improving its fundamentals. At the opposite, a sound business that is badly perceived by the market could have trouble raising follow-on capital and thus suffer a deterioration in its fundamentals. But he reminds us that "reflexivity is a minor factor in the valuation of most securities most of the time," and only occasionally becomes important.
Klarman ends the chapter discussing the limitations of Earnings, Book Values, and Dividend Yields as valuation foundations.
In his view, earnings have become such a cornerstone of valuation that management teams have developed many ways to manipulate it, causing it to lose relevance in investors' eyes. "Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend."
Book Value or the historical price at which an asset has been purchased (less depreciation incurred, which will be highlighted in the company's financials) can be wildly misleading to investors. In some cases, like real-estate, it is usually very conservative, since real estate tends to rise in value with time. Fully depreciated plant and equipment, again, are usually great pockets of value. Inventory, computers, software, and receivables, on the other hand, are trickier. "Inflation, technological change, and regulation, among other factors, can affect the value of assets in ways that historical cost accounting cannot capture."
Lastly, the author dismisses Dividend Yield as a useful measure of value: "Too often struggling companies sport high dividend yields, not because the dividends have been increased, but because the share prices have fallen. Fearing that the stock price will drop further if the dividend is cut, managements maintain the payout, weakening the company even more."
Key Ideas from Chapter 8
1. If a business is too difficult to value, skip it. "For every business that cannot be valued, there are many others that can. Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else."
2. Valuation is an art, and not a science. It is imprecise. Investors have to look for a range of values, that can point them in the right direction (that of a big margin of safety).
3. Investors should know the limitations of each valuation method, and use a variety of methods to arrive at a range of valuations.
4. NPVs are very precise, but of limited use: cash-flows are rarely predictable and choosing the right discount rate, almost impossible. Therefore, if used, they should incorporate a range of premises and a range of discount rates in a thorough sensitivity analysis.
5. Liquidation value is the most useful method because it is the most conservative.
6. Earnings should be taken with a -handful of - grain(s) of salt. Book value tends to be a bit more reliable: conservative in the cases of liquid assets, and discarded in case of assets that can become obsolete or hard too illiquid. Dividend Yields should be discarded.
That was indeed a long one! See you in a few days with the last part.