Value Investing Principle #3 (Part 2): Value Investors Love A Good Bargain

"The entrance strategy is actually more important than the exit strategy". – Eddie Lampert

"Plan before acting. Fight only when you know you can win." - Zhuge Liang

In the previous post on the Principles of Value Investing I introduced the concept of Margin of Safety and Intrinsic Value and answered the first of 5 questions that I posed:

(1) Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?

(2) How Do I Calculate the Value of a Stock?

(3) Why Not Pay the Fair Value for a business? Why Must I seek a Margin of Safety?

(4) How great a Margin of Safety do Value Investors generally demand?

(5) Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?

In today's post I will attempt to answer questions 2 to 4.

Q2: How Do I Calculate the Value of a Stock?

The important point to understand here is that calculating the Intrinsic Value of a business or stock is not an exact science. It is an estimate or a range between prices.

A simple example: Let's assume you are interested in purchasing a felafel stand. How would you calculate what price is a fair price you should pay for the business? Hopefully, you would look at 2 factors:

(i) Cashflow: You would try to assess how much cash the business will generate (cash flow) every year after all your expenses have been paid.

(ii) Growth Expectations: You will try to assess the growth potential of the business.

Now let's assume you do some research and discover that similar falafel stands in the area generate in their first year of operation an annual cashflow of $50,000, after all expenses have been paid. And let's assume that you discover that a similar falafel stand increased it's annual cashflow by 10% every year.

Would you pay $50,000 for the stand? Probably – as this means that you would earn back your initial $50,000 in one year. How about $100,000? Yeah, maybe. $200,000? Um, let me think about it. So you now have an estimate – in your opinion it is worth somewhere between $50,000 to $200,000.

If the seller of the falafel stand wants $1 million for it, you would immediately recognize that only a fool would pay such a price – even if there are hundreds of other fools paying similar prices for similar businesses elsewhere. On the other hand, if someone, for some reason offered to sell it to you at $25,000 – you would take a serious look at this deal.

In calculating the intrinsic value of stock, Value Investors apply a method called "Discounted Cash Flow" or DCF. The 2 main assumptions are free cash flow and growth. As much has been written by individuals far more capable than me, I will not go into the actual calcualtion or methodology of DCF. Instead allow me to point you to:

(i) An excellent article from the Motley Fool.

(ii) Joe Ponzio's FWallStreet - Joe's blog is first class - extremely well written, a shining example of an individual bringing value to the market. Specifically look at the 4-part series on The Value of a Business that begins here. You can also download a very good DCF excel spreadsheet which Joee used on his analysis of JNJ here.

Q3: Why Not Pay the Fair Value? Why Must I seek a Margin of Safety?

"One of the hardest things to imagine is that you are not smarter than average" - Daniel Kahneman, New York Times "Why Both Bulls and Bears Can Act So Bird-Brained", March 30, 1997

You haven't been paying attention, have you? Calculating Intrinsic Value is not an exact science – it is estimation only that requires two assumptions – a forecast for annual cash flow in year 1 and an estimated growth rate. As these are only assumptions – they can be wrong (and often are). You need to leave some contingency in the event that your assumptions are wrong.

Warren Buffett refers to the field of construction and engineering where the Margin of Safety concept is applied daily:

"You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing." - The Superinvestors of Graham-and-Doddsville

In his 1974 Letter to Shareholders Buffett wrote:

"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."

This is why I have always said that Value Investors earn their money when they place a 'buy order' - not on the sell. The skill is in buying well.

And in his 1992 Letter to Shareholders he said it again:

“What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).....The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value...... If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”

Q4: How great a Margin of Safety do Value Investors generally demand?

"If you understand a business and if you can see its future perfectly, then you obviously need very little in the way of margin of safety...Conversely, the more vulnerable the business, the larger the margin of safety you require." - Warren Buffett

As the Buffett quote suggests, the Margin of Safety that you give yourself is a function of to what extent you feel confident about forecasting a businesses cashflows and growth. Value Investors typically demand a margin of safety (or discount) of at least 30% (and sometimes as high as 50%) to calculated intrinsic value.

It is also worth noting that the greater the Margin of Safety that you give yourself, the lower the risk in losing your initial investment. The Partners at Tweedy Browne, a well-known Value Investing fund manager explains:

"One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater potential return when the stock price moves back to intrinsic value. Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e. lower risk."

In Part 3 of Value Investing Principle #3, I will attempt to answer Question 5 and discuss what the industry refers to as 'Value Traps'.

"May you possess the Wisdom to see what the Market does not, and the Courage to act on it".

Value Investing Principle #3 (Part 1): Value Investors Love A Good Bargain (Margin of Safety)

"Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety."

– The Intelligent Investor, Chapter 20, Benjamin Graham

"Good warriors prevail when it is easy to prevail. "
- The Art of War, Sun Tzu

In this post, and in the following two after it, I will discuss the ideas behind what is probably the most central concept in the Value Investing discipline: the 'Margin of Safety'. Benjamin Graham, the 'Father of Value Investing' introduced it to the investing world in his book, The Intelligent Investor.

Simply explained, the Margin of Safety principle demands that investors only invest in businesses or stocks that trade at a significant discount to their calculated 'true value'. This 'true value' is also called the 'intrinsic value'. In other words, if you calculate a stock's intrinsic value to be $100, you should give yourself a 'margin of safety' and only pay, say $70 or less for it. Makes sense, right? This is no different to when you go shopping at the supermarket: Pasta, which normally sells for $2 a pack is now on special, and priced at $1. You wouldn't think twice (unless of course you're allergic to pasta or the expiry date is way passed today's). Savvy shoppers will take advantage when items are on sale, and buy in bulk.

All this sounds like common sense, but I bet you're dying to ask the following questions:

(1) Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?

(2) How Do I Calculate the True (Intrinsic) Value of a Stock?

(3) Why Not Pay the Fair Value for a business? Why Must I seek a Margin of Safety?

(4) How great a Margin of Safety do Value Investors generally demand?

(5) Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?

In this post I'm going to answer only the first question. The others will be dealt with in the coming posts.

Q1. Does the price of a business or stock ever trade at a significant discount or premium to their true or intrinsic value? If so, why?

A1: Yes – all the time. Don't believe me? Open any newspaper, or financial website (Yahoo will do), pick any major public company and look at the 52-week high and 52-week low. Let's look at Teva (TEVA). The 52-week low was $30.70, pricing the entire business at around $23.39 billion. (To calculate the value of the entire business, mutliply the no. of shares that are outstanding by the share price). The 52-week high is $45.44, pricing the entire business at $34.62 billion. That's a huge spread – a little over $11 billion. How can this be? Which is the correct and fair price? Can a business change so significantly that it will have gained or lost $11 billion in value in the space of a year? The answer to all this is simply this: the market does not always behave rationally. Why not?

Two reasons that may explain this are:

(i) The market is sometimes driven by the emotions of greed and fear. For example, when an individual invests in a company without really researching it, because he heard from a neighbor that he made several thousand dollars from a stock that shot up 20%. That's not rational - it's insane. Imagine being told that the price of bread increased by 20% at a certain bakery. You wouldn't feel the sudden need to rush out and buy bread from that bakery. You'd look elsewhere for a better deal. Most people however, behave differently when it comes to the stock market. When hearing a stock or fund has increased by a huge amount, they feel that they are going to miss out on the profits and buy after the stock is has already increased in prive. That's greed talking. My neighbor, however, is smarter than that. If I tell him that I bought SanDisk at $37, and it drops to $36, he understands that he can get a better deal than what I got, and he calls his broker. Just like buying pasta on special at the supermarket. Right, Oren?

In Robert Hagstrom's, The Warren Buffett Way, (see also this post) he explains that the Value Investing methodology developed by Graham was based on the belief that the market is often wrong:

"Graham's conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market."

(ii) The market forgets that stocks are fractional bits of actual companies. Some individuals think of stocks as bits of paper that are traded back and forth. They rarely consider the business behind the stock - the products or services, the clients or employees. As Benjamin Graham wrote in Security Analysis in 1934:

"It is an almost unbelievable fact that Wall Street never asks: 'How much is the business selling for? Yet this should be the first question in considering a stock purchase."

"Why Both Bulls and Bears Can Act So Bird-Brained" - a New York Times article written a decade ago explores this in some depth. You can view it here.

So I think it's just about now where we learn the first Value Investing Mantra.

Repeat after me:

"The Price of a stock is not the same as the Value of a stock"

Most investors do not understand this principle, which explains why the market crowd is very often emotionally-driven, and does not behave rationally.

Value Investors focus on the Value of the business, not on the price of it.

As Warren Buffett famously declared: "Price is what you pay, value is what you get."

In the next posts I will continue our discussion on Margin of Safety and look at how intrinsic value is calculated, why you must seek a Margin of Safety, and how great a Margin of Safety is required. I will also briefly discuss 'Value Traps'.

Until next time - May you possess the Wisdom to See what the market does not, and the Courage to act on it.