In this video, I’m going to explain how value investing works
in 5 levels of increasing complexity.
We’ll be starting with the most basic explanation,
but as we approach Warren Buffett’s hometown of Omaha,
we’ll get more detailed.
So, jump on the value investing hype-train
(if there ever was such a thing),
and join me on this ride!
This is the Swedish Investor,
bringing you the best tips and tools for reaching financial freedom
through stock market investing.
First and foremost
- why would you want to spend 20 minutes of your life on a subject like value investing?
Because it’s probably the most reliable and proven investment philosophy out there.
For almost a century, it has created great fortunes for investors such as Benjamin Graham,
Walter Schloss, Charlie Munger, William Ruane,
Joel Greenblatt, and of course, Warren Buffett.
I have even used it myself to beat the market by about 200 percentage points over a decade.
After devouring many of the greatest works within the field,
this is what I’ve discovered.
Value investing is actually really simple
– all you really need to do is search for assets that you can buy
and insist that you get a bargain price.
An asset, in the eyes of a value investor,
is anything that can be expected to generate cash in the future.
Shares in companies, loans issued in various forms, and real estate
represent perhaps the most common types of assets,
but there are value investors who hunt for more obscure things than that.
Seth Klarman, for example, famously invested in claims against the massive Ponzi scheme
of Bernie Madoff.
After finding an asset that you understand,
you should insist on a bargain price.
Basically, you are going on a treasure hunt.
Value investors aren’t pirates, of course;
we’re not trying to steal anything.
Rather, we are shopaholics.
When one-dollar bills are being offered for 50 cents, we go on a spending spree.
Buying, however, is just one-half of the value investing formula
(although it is the most important half …).
There is also selling.
A value investor sells his assets when they are no longer bargains.
So, when others are willing to buy back those one-dollar bills at close to a dollar,
we pocket the difference.
In reality, these statements are too vague to act on.
You’re probably already thinking:
“Alright, but when is an asset a bargain and where do I find one?”
Let’s start with what creates a bargain.
It’s cash.
Value investors follow the flow of cash like a bloodhound.
Investors in real estate look at tenant’s payments minus expenses,
investors in bonds look at interest payments and the repayment of the principal,
and investors in stocks,
although I’m simplifying a little now,
look at earnings per share.
In theory, any investment is worth the net amount of cash that it pays out to its owners
from today until judgment day.
Let’s observe what the two value investors Arnold and Tom are doing.
They’re both obsessed with cash flows, like all value investors are.
Arnold has bought $1,000 of 10-year US government bonds that pay him $40 per year.
Arnold’s return is 4% per year, $40/$1,000.
Tom has purchased shares in the public company PepsiCo.
They currently earn $7 per share,
and they cost $180 each,
so his return is also 4% per year, $7/$180.
This is the E/P ratio, and it is better to use than the more commonly known P/E ratio
because it is easier to compare to investments outside the universe of stocks.
For Arnold’s bonds, the payment of $40 per year is fixed,
but that’s not the case with PepsiCo’s earnings.
If the earnings increase in the future, Tom’s return will be higher than 4%.
PepsiCo has more than doubled its earnings per share since 2007,
so we have a good reason to believe that it will increase in the future as well.
At this stage, we could expand our definition of value investing to
“buy assets with cheap cash flows and sell them when they are no longer cheap.”
As it seems like Tom purchased a superior stream of cash flows for the same amount of money
can we conclude that he’s the better value investor?
Well, maybe, you know I like Tom, but before we get to that, let’s talk about Felix.
Felix just purchased an NFT representing a Picasso painting for $1,000.
He hopes to resell this NFT to someone else at a higher price somewhere down the line.
Is Felix a value investor?
Unlike Arnold’s and Tom’s investments, Felix’s has no cash flows.
The father of value investing, Benjamin Graham, would say that the NFT has no “intrinsic value”.
The intrinsic value of an investment is independent of its market price.
Essentially, think about it as the value of an asset as if you could never sell it.
The NFT throws off exactly $0 per year,
you know, year after year after year after year,
and the only way that Felix can expect to make any money on this lazy investment
is by selling it to someone else.
A value investor is never dependent on a resell price.
Both Arnold and Tom are perfectly happy if no one ever wants to buy back their securities,
as they can just sit on them and collect the cashflows.
That’s the primary difference between a value investor and a speculator.
Value investors adhere to the wisdom of Mark Twain, who said:
“There are two times in a man's life when he should not speculate:
when he can't afford it, and when he can.”
Value investors can distinguish between Picasso and PepsiCo.
Let me ask you a rhetorical question:
Would you rather have $1 million today or $1 million in 20 years?
The answer should be quite obvious,
not only because money may have more utility for you when you are younger,
but also because money can be used to generate more money.
It matters not only how much cash flow we receive from our investments,
but also when we receive it.
The sooner, the more valuable the investment.
This is the core of the discounted cashflow (or DCF) analysis where we use a discount rate
to reduce the value of future cash flows.
If we use a low discount rate,
money in the future is worth quite a bit,
but if we use a higher one, the value diminishes quickly.
After we’ve taken the time value of money into account,
we simply sum up these reduced cash flows to see how much the asset is worth today.
This of course raises an important question:
How much less is cash in the future worth?
It depends on how well you expect that you’ll be able to perform as an investor.
One might, for instance, use the historical average that the stock market has returned,
which is around 8-10% per year.
The greatest value investors, such as Warren Buffett,
use a sort of moving target that depends on where the US 10-year currently stands.
Also, they never settle for less than the historical average of 8-10%,
no matter where the 10-year is.
We can update our value investing formula to
“buy assets with cheap discounted cash flows
and sell them when they are no longer cheap.”
However, a word of caution here.
Although your college professor in finance probably wouldn’t like to admit it,
actually plugging values into a DCF model
is something that the greatest value investors rarely do.
Why?
You know, Warren talks about these discounted cash flows.
I’ve never seen him do one.
Yeah.
If it isn’t pluperfect obvious that it’s going to work out well, if you do the calculation,
he tends to go on to the next idea.
Yeah, it’s sort of — it is true.
You don’t —
if you have to actually do it on —
with pencil and paper,
it’s too close to think about.
I mean, it ought to just kind of scream at you that you’ve got this huge margin of safety.
Simply put – if you must use a DCF model
to verify that you’ve found a good investment opportunity
it isn’t good enough.
That’s not good enough!
Benjamin Graham would say that there isn’t a big enough margin of safety,
a really important concept that we’ll get back to later.
The greatest value investors know in their spine that
future cashflows are worth less than cashflows today
and that the return you require should differ with the economic climate,
but they stay clear of calculating net present values with many decimal points.
For example, it is perfectly obvious that the US 10-year is not going to be able to
make Arnold that minimum 8-10% return per year.
In fact, even Tom’s investment in PepsiCo seems highly unlikely to yield something like that.
He doesn’t need to enter numbers into a spreadsheet to understand that.
Luckily, for us and our illustration here,
Tom recently found out about the Swedish gambling company Kindred.
The earnings of Kindred are a little more volatile,
but if we assume that the company can earn $0.9 per share moving forward,
they are already at an 8% earnings yield.
Moreover, its historical growth is even more impressive than that of PepsiCo.
Again, Tom needs no DCF analysis to understand
that a company with this type of historical performance
at such a price tag has at least the potential to return more than 8-10% per year.
However, he does need one more thing …
The value investor is always looking to get as much return as possible for a given risk.
When this relationship is really skewed,
the value investor can be said to get a bargain.
Unfortunately, assets do not come with nutritional facts revealing precise risk numbers.
“I know that investment, it’s 42 grams of risk per 100.”
No.
Here’s Warren Buffett’s definition of risk:
I mean, that would be part of our course on how to value a business.
It would also be, how risky is the business?
And we think about that in terms of every business we buy.
And risk with us relates to …
Well, it relates to several possibilities.
One is the risk of permanent capital loss.
And then the other risk is just an inadequate return on the kind of capital we put in.
Basically, the risk that our assumptions about the predicted cashflows are wrong
or that we paid too much for them.
With that in mind, let’s get back to Arnold and Tom and the investments that they are considering
– bonds, PepsiCo and Kindred.
We’ve said that Arnold’s return is 4% per year,
assuming that he’ll get a coupon of $40 per year for 10 years
and then his $1,000 back at the end of it.
Are there any risks that the US government won’t be able to pay him back?
Nah, I highly doubt it.
However, there is a risk that his coupons do not end up being as valuable as he thinks
due to inflation.
Because of this, Arnold’s investment scores very low on the risk-return scale.
Now, what about Tom’s idea to invest in PepsiCo or Kindred?
A few risks that I always like to think about before I invest in public companies are these 5:
Competition,
Management,
Regulation,
Suppliers and Customers.
They all have the potential to ruin our guestimates about future cash flows.
- Competition – has it increased lately, are there strong up-and-comers?
PepsiCo’s industry is more or less a duopoly, while iGaming is more fragmented.
- Management – is it stable and trustworthy?
Is the management invested alongside their shareholders?
There’s been some flux in PepsiCo’s management lately,
and insiders hold around 0.2% of the company
which I think is a fairly low number.
In Kindred, there’s also been some flux at the top management level,
and managers hold 1% of the company, which isn’t too much either.
- Regulation – what’s society’s standpoint on the industry?
Is it likely to cause trouble?
For PepsiCo, I think this risk is negligible, but it certainly isn’t for Kindred.
Regulators change their opinion on online gambling all the time.
- Suppliers – are input costs likely to increase?
Is the company dependent on a single or a few key suppliers?
PepsiCo does what Warren Buffett likes the best
– buying commodities and selling brands.
Kindred has more risk here as they are dependent on a supplier called Kambi for their sportsbook, for example.
- Customers – are there only a few big customers or are there multiple ones?
Will customers continue to buy even in an economic downturn?
Both of these businesses are B2C,
and they sell products that are in demand no matter the economic cycle.
When Tom pits these two companies against each other,
I think it should be clear that Kindred is riskier than PepsiCo.
The implication is that Tom should require a larger margin of safety
when investing in Kindred compared to PepsiCo.
Seth Klarman probably explained the concept of a margin of safety the best:
“A margin of safety is necessary because valuation is an imprecise art,
the future is unpredictable,
and investors are human and do make mistakes.
It is adherence to the concept of a margin of safety
that best distinguishes value investors from all others,
who are not as concerned about loss.”
With that said, we can update our explanation of value investing to:
“buy assets with cheap discounted cashflows,
using a margin of safety,
and sell when there is no longer a margin of safety.”
Once again, just like the DCF analysis,
this is only a guiding principle for the greatest investors,
not a rigid formulaic approach.
Here are three examples of a margin of safety:
- When a company is already yielding as much as you require
and it is also growing, such as Tom’s Kindred.
- When a company is currently yielding more than you require
- When a company is yielding about as much as you require,
but it also sits on a massive net cash position.
Benjamin Graham is famous for having loved this specific type of margin of safety
that can be found on a company’s balance sheet.
At a strange and charitable auction house in the US,
where cell phones aren’t allowed,
the following takes place.
“Today we have something really special for you.
10 $100 bills, as real as they come!
We’re accepting your bids!”
The people in the auction start to bid up the price.
“$300!”
“$600!”
“$900!”
“$999!”
“Sold to the man in the grey suit for $999!
Now, our next item is something even more special.
Here’s 100 notes of 1,000 Indian rupees!
Let the bidding war begin!”
After 30 seconds of hesitation, Cathie gets up and says:
“Ehm … $300!”
“Sold to the lady in the grey suit for $300!”
Now, what happened here, and why is this analogy important for value investors?
When value is too obvious, it is seldom possible for investors to find true bargains.
Why?
Because prices are bid up too high.
Netting $1 is quite nice, but not that impressive.
The 100,000 Indian rupees, on the other hand, were a true bargain.
Cathie knew this and she downplayed her confidence on purpose.
She had no competition here, zero.
Although this is a dumbed-down version of reality,
I hope that it conveys the message.
Value investors’ primary hunting grounds are in assets that are disliked and/or overlooked.
Value investors are contrarians,
we search for opinions that differ from the crowd.
For example, there are currently 26 analysts, according to Yahoo Finance,
who have an opinion about what the earnings per share of Apple will be in the next quarter.
When so many people try to dissect a company,
it’s very unlikely that you can ever pick it up at a large discount from its intrinsic value.
Well, where should we look, then?
Here’s how three famous value investors find disliked or overlooked assets:
Seth Klarman says that you can look at lists ranking the biggest stock market losers of,
for example, the last year.
Why the losers and not the winners?
Because it is too popular to invest in the winners,
so they seldom represent bargains.
The young Warren Buffett used to search for overlooked securities listed in places
like the Pink Sheets.
This list no longer exists,
but if you want to emulate his approach,
just screen for companies with market caps of,
say, less than $100 million.
My preferred approach comes from Joel Greenblatt,
who uses a quantitative system called
The Magic Formula to find his investments.
If you want to know more about it,
head over to my summary of The Little Book that Beats the Market.
The funniest approach to finding overlooked assets comes from Peter Lynch, though.
In his book One Up on Wall Street,
he says that he is looking for companies with boring names
and those that are in businesses that others find distasteful.
Think oil, gambling, weapons, porn, or funerals.
The closer we are to danger, the farther we are from harm.
So a value investor attempts to:
“buy disliked or overlooked assets with cheap discounted cashflows
using a margin of safety,
and sell when there is no longer a margin of safety.”
Cheers!