The Unrepentant Recalcitrant

Lessons for an accidental entrepreneur

Archive for the category “Valuation”

There is only One Strategy. All else is Tactics

In investing as in business (and life, if you will give me the leeway), there exists only one strategy.

Its the same for everyone regardless of the ostensible differences in situations.

Say What?

You heard me.

A very smart guy called Bruce Greenwald introduced me to this idea (More on him below. Be sure to read his book).

Warren Buffet swears by it.

Mark Zuckerberg and Sergey Brin understand it.

Coca Cola is a success because of it.

So, what is it?

Listen carefully now.

The only strategy that you need to understand in business is that of creating a competitive advantage.

A Moat around your castle. An impregnable defense.

No business should be thinking about anything else.

Everything else you do is a tactic and should be geared to supporting the strategy.

More importantly, everything you do should measured against this strategy.

If it does not create or widen your moat, its a waste of your resources and time and will land up damaging you.

If you are an investor and you observe your investment wasting time and effort in tactics that don’t propagate the moat, you better sell brother.

Buffet tells his managers to use their resources to widen their business moats.

Not to ensure an ever greater profit every year. Not to increase revenues.

Just focus on widening the moat.

Everything else just follows.

The best businesses have moats that are very difficult to overcome.

This allows them to abuse a fundamental economic principle (one of only two or three that matter).

The principle (I have mentioned this before) is that all profitable businesses will encounter competition (the more profitable it is, the more the competition) and this will continue until all profit is reduced to zero.

The natural state of things according to the dismal science (economics, for those of you new to this term!) is perfect competition and zero profit.

 All profit that endures beyond zero is termed “abnormal earnings”.

 As we discussed in an earlier post, this represents the return on invested capital (EVA).

The existence of a persistent positive return on capital (i.e. its greater than the cost of the same capital), implies that there are exceptions to the economic rule above.

The only way this is possible (The Only One!) is if there is a barrier to entry for competition or a moat.

Even those who want to compete with you, cannot.

You continue to earn more than your cost.

You are indefinitely profitable (To an extent! Another economist said, “In the long run we are all dead!”).

I will talk some more on the chameleon like nature of a moat later when discussing the various forms it can take (just like Avatars for those of you into hindu mythology!).

I want to relate this concept to your life before I close today.

Answer me this:

To what end is all the preparation you do in your life?

Why do we go to school? Why do we go to college?

What does our resume and experience mean?

What do we strive for, when we strive for “success”?

Differentiation, pure and simple.

If you don’t stand out, you can be (and will be ) replaced.

You will inevitably sink back into the human morass of identical and exchangeable.

If there is something special about you (read moat), you are differentiated.

You will continue to succeed in life because you have your own little human moat.

Everything is connected. The truth is singular.

Think about it.

PS: Bruce Greenwald is a Professor at the Columbia Business School.

 Get a hold of his book “Competition Demystified”.

 You will thank me.

Advertisements

Index Fund Investing has a Dirty Little Secret

Don’t get me wrong.

Its better than speculating or gambling.

If you absolutely have no other choice, it may be the way to go.

(If you must index, consider buying the index after a market crash and selling it at the market peak. I acknowledge its easier said than done.)

As always, you should know what you are getting into.

An index fund is an investment in a basket of companies (which companies and how they are chosen is a separate bugaboo of mine).

At the point of your purchase some of these companies are fully valued (i.e. P=V).

Others are undervalued (P<V).

Still others are beginning their plunge into obscurity (P>>V).

Which is which you ask?

You would have to go over each business in order to understand the answer to that question.

But it doesn’t matter.

Because you buy the whole basket.

When you buy the whole basket, you buy everything at market price.

You buy the overpriced assets at a premium and the under priced assets at a discount.

When the price (not value, since you don’t know value of several hundred companies each bought at market price) changes, what do you learn about your investment?

Nothing. Absolutely nothing.

I repeat. Because you buy the whole basket!

How do you know when you should sell and when you should buy?

If you agree that you should buy low and sell high as an investor, you must also agree that you cant do this if you cant value the basket.

You are more prone to market hysteria and the craziness of Mr Market.

You will have a hard time knowing when the market is wrong and when it is right.

The balance of fear and greed that Warren Buffet says you must keep in opposition to the market, will know lean toward the market.

There is a much higher likelihood that you will bail at the wrong time and buy in at the wrong time.

I don’t blame you for making this mistake. When the index loses 25% of its value in a plunge, how do you know what to do if you don’t know what the companies in the index are actually worth?

With an index, you don’t have an independent frame of reference like you do with an individual stock (P/V, EVA etc, remember?)

This is the single biggest reason why people investing in index funds don’t make the same return as the index does. They respond to fear and greed the wrong way.

Find a way out of this trap.

Give it some thought.

 

Valuation and its Discontents

The cornerstone of investing and entrepreneurship and perhaps even of life, is valuation.

Thats not hyperbole.

Think about it. You are valuing and weighing all day long, every day.

Obviously you need to value stocks and bonds if you are to invest.

Its also evident you want to understand how much your business is worth if you have a startup.

But there is more.

Whats that house you want to buy worth?

How about the car you purchased last year?

Do you value your collectibles? Your art?

How do you do that?

Lets go into uncharted territory.

Do you value your relationships? Looking for a girlfriend?

What is she worth?

(Its only a little tongue in cheek. Later, someday I’ll explain why. For now, we will stick with inanimate objects!)

As I described in an earlier post, we are putting a value or worth on assets (remember assets?).

Value and worth, as I have said before need not necessarily be the same as the price of the asset.

If its less than the price of the asset, we have an investable opportunity. Otherwise we don’t.

Lets use the value of a company stock as an example.

What is it worth?

There are many ways to determine this but a few that are important to consider.

Lets talk about four of them.

1. Asset Valuation
2. Liquidation Value
3. Replacement (or Competing) Value
4. Discounted Cash Flow Valuation

Asset valuation:

One way to assess value is to add up the worth of all the things the company owns…its buildings, its inventory, its machines and its cash and calculate its total asset value.

Lets say, you are in the middle of a depression. Companies are selling cheap (ca 1929).

It was possible to pick up companies at the time for less than the sum of their parts.

Benjamin Graham, the father of value investing made his fortune this way.

Liquidation Value:

A second way, in the case of a company that is being broken down and sold for its parts (liquidation value) is the total value of its assets minus some discount to account for the fact that everything it owns may not bring market value since it will be sold at fire sale prices.

More on this another day.

Replacement Value or the Valuation to Compete:

A third way to calculate value is to see the business as competition to us, and ask the following question:

“What would I need to do to build up a business just like this one and compete with it?”

Now that would include the asset value mentioned above but also the resources that have been deployed to build the brand(s), market the product(s), establish the customer and wholesaler relationships and distribution channels (among other things).

There is some hand waving involved here of course but its easy to see that the value of these intangibles (and semi intangibles) will add to the raw asset value we have described above.

Discounted Cash Flow valuation:

Finally, we can determine value by asking this question?

“If I owned this asset, what amount of money would I earn from it over a set period of time?”

If you owned a stock, what is the total value of dividends you would receive for it over time?

If you owned a whole business, what profit would you be able to get out of it every year for the duration of your ownership?

For each of these questions, we can (theoretically) construct a model of “cash flows“, i.e. the flow of money into your pocket over time.

Add that cash up.

Remember, you don’t have the cash in your pocket today. Its going to take time to get it all.

Over that time, you will live without that spending power.

So, the raw total of that cash must be “discounted” over the period you will need to get it into your pocket.

This is, in a word the discounted cash flow model of earnings (DCF) that allows you to estimate the value of an investment.
The discounted cash flow model of valuation (DCF) is de facto the most important method to understand, when valuing an asset that brings earnings.

Its incorrect to value a business with sales any other way (except in the situations I noted above).

I will speak more about DCF in later posts as it comprises the “V” in the “P/V” formula I introduced in the previous post.

I will leave you with a few final thoughts.

1. You cannot fully value an asset without cash flows (or the future promise of cash flows).

2. If you cannot fully value an asset, you cannot be sure of the relationship of Price to Value (P/V).

3. If you cannot estimate P/V and ensure a margin of safety, you are unable to ascertain whether an asset is investable.

4. If you decide to purchase the asset anyway, you have not invested. Rather you have speculated or gambled. Be clear on this.

5. Ergo, any asset without cash flows is not likely to be an investment.

Let me repeat that last statement.

An asset without cash flows is not likely to be an investment.
(Ahh…the chaos that idea will create!)

Principles of Value Investing

Toto, I have a feeling we’re not in Kansas anymore.

Yes boys and girls, put away your Excel spreadsheets and gather round the fire.

As Steve Jobs liked to say, “I’m going to tell you three things. No big deal. Just three things.”

That’s it folks.

Three Principles.

1. P/V
2. EVA
3. Rain Falls Down

( Bonus: They apply universally and are equally and importantly relevant to entrepreneurship as well.)

Before you swoon in admiration of my unparalleled genius, I want to be clear that these ideas and even the phraseology are not mine.

This is what I learned from my master, my Yoda. (Thanks Tom, for changing my life!)

Yes folks, this changed my life. If you pay attention, it might do it for you.

And then again for those of you too lazy to listen, it might not. YMMV.

 

Definitions first and details later. Ok?

 

1. P/V : Price/Value

The fundamental metric of all investing. The ratio of the price you pay for the value you get. This needs to be less than one at all costs and the lower it is, the larger your margin of safety (remember margin of safety?: https://unrepentantlyrecalcitrant.wordpress.com/2013/10/10/all-investing-is-value-investing-the-rest-is-speculation/).

All of Wall Street that makes money off of you, conflates price and value. It is the fundamental thesis of those that believe the markets are efficient.

(If you believe that, what in gods name are you doing on my blog? Go visit that fool Cramer on CNBC or something!)

Price is what you pay, value is what you get.

The lower the price and the higher the value, the better the deal.

Buffet talks about buying a dollar for fifty cents.

That’s a P/V of 0.5

Awesome.

I will discuss the estimation of value in some detail in a later post.

 
2. EVA : Economic Value Added

Also known as Abnormal Earnings ( Economists always think that profit is an abnormal situation!), EVA is defined as:

Return on Invested Capital – Cost of Capital = EVA

As an example, if your capital costs you 9% ( say a bank loan for your business) and you are able to generate 9.9% return ( savvy investing or your business profits), you have an EVA of 10%

Needless to say, it should be a positive number!

Before you laugh at that, I will in the future show you why most businesses (the majority) are not getting a positive number and as a result have a zero EVA (bad!) or even a negative EVA ( yes, they are destroying capital!).

If you are an aspiring entrepreneur, you must (MUST) have plans for a positive EVA! If not, don’t even bother. More on this later.

 
3. Rain Falls Down:

A little more fuzzy than the others, this statement underlines that certain things are an inevitability.

You must prepare for them and account for them in your estimation of value and decision to invest ( or grow your business).

Your resistance to rain clouds and gravity is useless. Rain will fall down.

 
Simple so far, no?

Remember, Value investing is simple but it’s not easy! Oh No!

I will take each of these points and expand on them in future posts.

I will review the only economic principle(s) that matter ( YES, most of economics is a massive waste of your time!)

The only thing I can’t help you with is mental toughness.

(You need to review Kipling’s poem again and internalize it!: https://unrepentantlyrecalcitrant.wordpress.com/2013/10/06/rudyard-kipling-was-a-value-investor/)

Oh, one last thing. You know that money you saved up to buy the latest Excel program?

Go get a great dinner instead.

You ain’t gonna need Excel anymore.

The Emperor is Naked: Eugene Fama’s Nobel Prize

I was going to write about valuation this week but the events of last week caught my attention.

Oh the irony!

In the story “The Emperor’s New Clothes”, the only person to challenge the Emperor and point out that his new fashionable outfit was nakedness, was a little boy on the side of the street.

Not that Professor Shiller of Yale University is a hapless little boy.

The irony here is that both the Emperor and the little boy were awarded the Nobel (and are having to share it!).

The buffoons here are the Nobel committee (I know..there are no Nobel prizes for economics…but its close enough).

If you are so afraid to offend (alternatively if you are too simple minded to realize that these economists disagree on fundamental issues…fundamental issues) that you take the path of awarding them BOTH the prize (helped us understand how markets work…rubbish!), the only analogy this doctor can think of would be to award both creationists and evolutionary biologists the Nobel prize in Biology together “for clarifying the origins of man!”

I gag at the thought.

Eugene Fama believes the markets are efficient.

If you question him closely, he coyly adds/edits that he believes they are “informationally” efficient.

In other words, if you invoke human psychology (as Shiller does), Fama will tell you he is thinking about the dissemination of information being efficient.

The fact that informational efficiency in and of itself is a completely useless factoid is left unsaid.

Its the market’s actions that mean something.

I give a hill of beans that all of us have access to the same stupid analysts report.

It matters how you process that information and what you decide to do with it.

It matters whether it encourages the fear in you or the greed in you.

That’s what I want to know.

There is a silver lining here though for all of us who want to live in the real world (Fama has also said..there are no such things as financial bubbles..oy vey!).

The fixed false belief in efficient markets (in psychiatry, a fixed false belief is the definition of delusion..a belief that is unchanged in the face of contradictory evidence) has created substantial inefficiencies in the market.

The more people behave as if the markets are efficient, the more there are value anomalies that a savvy investor can exploit.

As Buffet said and I paraphrase ” If the competition goes to work every day thinking its useless to even try (to beat the market), it makes my job easier!”

I can hear Buffet and Munger as they fall off their chairs laughing at this turn of events.

Short term price movements, the kind likely to be impacted by Fama’s theory are irrelevant or should be irrelevant to all investors. I plan to discuss the (non) impact of short term price movements in a future post.

In the meantime, I hope and pray(!) that the creationists are not in line for a Nobel prize as well.

Are you listening Nobel Committee?

All Investing is value investing. The rest is speculation

Value Investing. Growth Investing. Momentum Investing. Trading. Real Estate. Precious Metals. Shorting.

A million different ways to lose your money (We should include failed startups to this now shouldn’t we? Heh Heh).

I am going to review some of the lessons I have learned about investing over several future posts but lets spend some time clarifying what we are talking about. Being exact is helpful in a situation where we are surrounded with many different voices in chaotic confusion.

An asset is something that puts money in your pocket either today or in the future. Today it might be cash in your pocket, and in the future it may be the result of an investment, a gamble or a speculation.

Value Investing (or Investing) is the act of acquiring an asset for less than what its worth. Once the asset reaches the point where it is valued at what it is worth (or more), we have made a profit. Agreed?

Speculation is the act of (well speculation, I guess!) an informed (yes, informed…maybe incorrect but informed) betting on the movement in the price of an asset or a presumed asset. If the speculation is correct, a profit is made, and if not, a loss is suffered.

Gambling is the act of largely (not uniquely, no) uninformed speculation that most often results in losses for the gambler and winnings for the counter-party. The counter-party may be a speculator or an investor.

Now lets be theoretical for just a second and invoke math (or maths, if you are British). The only guarantee of profit in the above scenarios comes from buying an asset for less than its worth, i.e. value investing. Its more complicated than that but lets start with the numbers.

When you speculate, you position a bet to take into account certain unperceived or less perceived visions of a future wherein the asset you purchase will sell for more than you paid for it, regardless of whether it is worth what you paid or what the next person pays you for it (Greater fool theory).

That last bit is important. Its important because it underlies the idea of “margin of safety”. The concept of margin of safety says that you have purchased an asset for so much less than it is worth, that even in the likelihood that the greater fool theory did not apply, you would either minimize your losses or make a profit when the asset is fully valued.

A value investor lives or dies by his margin of safety.

A speculator is less concerned by it.

A gambler does not even know it exists.

Every situation where you buy an asset for less than its worth is therefore an example of value investing (stocks in 2009, real estate in 2010, Europe for the longest time etc).

Every time you don’t do that but you believe something good will happen to you, (i.e. currency trading, buying and selling gold, real estate in 2007, European debt over the past few years etc), you are speculating. There is nothing wrong with it, but its good to know what you are doing very clearly isn’t it?

The difference then between these two methods of generating wealth is therefore predicated on whether there is a difference between the price of an asset and its intrinsic value. That in turn is predicated on the estimation of value, the most important item in our arsenal.

Let me be very clear on this so there is no doubt where I stand. If you are unable to ascertain the value of an asset, you are a speculator and if you don’t even know that there may be an intrinsic value that you are missing, you are a gambler and one that will lose to the house every single time.

Every single time.

You have no business investing/speculating/gambling if you are unable to ascertain value.

Am I clear?

Would you perform surgery on yourself without going to medical school?

Exactly. (sigh..I can see the gamblers in the audience going..Hmm.. Why not give it a try?)

If you insist on doing this without the fundamental knowledge of valuation, I have some news for you. You have a name on Wall Street.

Sucker. Muppet (if the counter party is Goldman Sachs).

Warren Buffet says and I paraphrase “Every game has a sucker. If you don’t know who that sucker is, its you. Sucker”

I know the wider world thinks buying and selling stocks and “playing” the market is easy. Dead Wrong.

The market makes its money off of you.

Ok, lets summarize what I said so far.

The least risk (or most sure way) to generate positive returns is by investing and specifically by buying an asset for less than it is worth.

Speculation done well is an art that is beautiful to behold. Some of the richest people in the world are successful speculators. However, its extraordinarily difficult to do and to do it consistently over time is a rare feat. When you see the best at their game, its sometimes difficult to tell whether they speculated or whether they are very savvy value investors.

Most speculators are lousy and should be reclassified as gamblers.

Its more risky and much more stressful.

I don’t need to say anymore about gambling, do I?

Whats next?

In future posts I will discuss the concepts of valuation, its pitfalls and what you must learn in order to perform a reasonably good valuation.

We will then go over the principles of value investing (There are only three principles, my wide eyed acolytes, so don’t worry!!).

Among these posts in the future, I will discuss why these principles can and should be generalized to entrepreneurship and perhaps even to the Right Thinking principles I have been discussing so far.

Flood me with your comments, but please only positive ones.

I have a fragile ego.

Post Navigation