What Value Investors Look for in Quarterly Earnings Reports

Well we're just about nearing the end of the reporting season for quarter 3, 2007, and I thought it might be an opportune time to briefly discuss quarterly earnings announcements - and what Value Investors generally look for.

True - Value Investors do not focus or judge companies on quarterly earnings performance, but rather assess a company on its performance during different parts of the long term business cycle. This however, does not mean that Value Investors do not pay attention to quarterly earnings reports.

Quarterly earnngs reports allows Value Investors to extract 2 qualitative dimensions about a company and the industry it operates in:

(i) Quality of Management - Is Management shareholder-oriented? Is it open, candid and honest in the manner it reports and answers questions?

(ii) Industry Changes - what's going on in the industry? Have any fundamental changes occurred?

I have always found Morningstar's research and website a great investing resource. (At the right price, Morningstar Inc (Ticker: MORN) would be definitely worth looking at). Anyway, I came across the following 3 minute video by Pat Dorsey, Director of Stock Analysis at Morningstar.

If you've got a few moments, have a look at the video below. If you like what Dorsey has to say, I highly recommend his The Five Rules for Successful Stock Investing - it's a great book for a Value Investor that is just starting out.

Below is a brief summary of the tips that Dorsey provides, as well as a few insights and recommended resources of my own.

Earnings News or Earnings Noise, July 2007

(1) Don't focus on the the quarterly earnings number - it is the least relevant. If there is only one thing you should take away from Dorsey's advice it is this:

(2) Ignore the Headlines - face the facts - it is only natural that companies will 'put their best foot forward' and report in a manner that optimizes how they look. Most public companies hire PR / IR consultants whose job it is to frame them in the best light. So the challenge before Value Investors is to cut through the PR jive and get through to the nitty gritty.

(3) Focus on Why, Not What - Revenues are dropping? Margins are eroding? Inventories are building up? You've got to be asking yourself 'Why?'. Why is this happening? Is this a new trend? Has something changed in the industry? The answers to the "Why' question are usually what alerts Value Investors to significant changes in the industry. (To see why this is high importance take a look at this).

(4) What Do You Want To Know - Before the earnings release, Dorsey recommends that investors should make a list of what they want to know from the earnings release. I totally agree. By taking this step, you move from being in 'passive mode' where the company information is 'dressed up' and 'fed to you', to 'active mode' - where you in control of what you seek. It is a good sign when a company is able to answer all your pre-prepared questions. It means that they are being upfront and candid with investors, telling it exactly as it is.

(5) Listen to the Conference Call - There is so much qualitative information that can be gleaned from company conference calls that the importance of this tip cannot be understated. These days, almost all public companies in the US allow investors to listen in on the conference call via the internet or via phone. The investor relations section of the company's website will tell you how to do this. Generally, these calls are divided into 2 parts: a pre-prepared statement (which is usually read out by the CEO / COO /CFO), and then a Q&A section where industry analysts ask questions. It is the second half of the call that I find of greatest value to me. These analysts typically know the industries they cover like the back of their hands. It's their bread and butter. Remember - they are most probably covering the company's competitors as well - so they should be able to recognize shifts in industry trends. So pay special attention analysts' questions - they may raise some important red flags. Equally important is how the company's management answers analysts' questions. Are their answers open and candid ('yeah - we really messed up' or 'we really don't know') or are they defensive and evasive?

The following tip may be too much for some investors, but I also like to re-read the earnings transcript for the previous quarter. If you make a habit of taking notes, then you just re-read those notes. You should take note as to what extent the company's management is optimistic and upbeat.You should also note any forecasts of growth - even if they are somewhat vague. (you'll get used to the lingo - single-digit, double-digit, low teens, high-teens). By doing this you can then compare what they said last quarter to what they are saying now - and immediately identify any changes. An Israeli company that I have been watching closely and which is releasing it's Q3 earnings report tomorrow may provide a prime example. Stay tuned.

A Great Resource for Quarterly Earnings Transcripts: Check out Seeking Alpha.

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

In the previous 2 posts on Value Investing Principles (here and here) I looked at the concepts of Margin of Safety, and Intrinsic Value. I explained that the calculation of the intrinsic value of a business is not an exact science but rather a rough estimate of value, hence the need for a margin of safety.

As promised in my previous post, in this post I am going to attempt to answer the last of the 5 questions that I posed:

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 attempting to answer this question I will introduce a new Value Investing concept - 'The Value Trap' . I'll also explain why some investors tend to be fooled by Value Traps, and in a later post will provide some advice on the best way to recognize them.

Drawing on the metaphor I used in the first post, imagine you are shopping and you see packets of pasta at half price. Instinctively you may want to take advantage of the bargain and buy in bulk. Savvy shoppers will immediately ask 'where's the catch?' - and will attempt to identify something faulty with the good (perhaps the pasta is close to its expiry date or is of poor quality). If you've discovered a valid reason why a product is 'on special' or trading at a significant bargain to market prices, you have discovered a 'Value Trap'.

Simply put, I define a Value Trap as a company that appears to be undervalued and a Value Investing opportunity, but in fact does not possess any recognizable significant investment potential.

So, to answer the question I posed: In my humble opinion I believe that for the most part, when a business is valued cheaply, there is a good reason for it and I seek to identify it. Most of the time, the market is to a large extent correct. This is expected. Never in the history of mankind have investors had so much company and industry information available at no cost, and never have they been as savvy and educated.

There are instances, however, when the market has mispriced or undervalued a business with little justification. These include:

(i) When it focuses on the Short Term and ignores Long Term potential: I think this is a primary reason for pricing inaccuracies as analysts and investors with a short term investment horizon focus solely on quarterly earnings. Long Term Value Investors take advantage of such short-sightedness to pick up quality companies cheaply.

(ii) The Market Confuses Uncertainty with Risk - this is a underlying theme of Mohnish Pabrai's investment philosophy. You can read about it in detail here. Basically, investors tend to react in simialr fashion when there exists business uncertainty as when there exists business risk - they panic. Two recent examples come to mind: in 2005 Mercury Interactive's CEO and CEO were accused of fraud with regards to the backdating of options. The market responded with a significant sell-off and drop in market price. Mercury's business and clients had not changed. The only difference is that 2 of Mercury's former senior management would now be wearing orange overalls. Hewlett Packard was able to take advantage of the negative market sentiment and less than a year later to acquire the company for $4.5 biliion in cash. A similar story occured with M-Systems and an internallly-initiated options backdating enquiry which resulted in the market severaly overeacting. Nothing had changed in the business at all, but the end was the same as Mercury's. SanDisk took advantage of the negative market sentiment and low share price and acquired M-Systems for approximately $1.5 billion

(iii) When Investors Do Not Properly Understand The Business: Sometimes investors do not understand the fundamentals of a specific business, and when certain industries face negative sentiment, these businesses included and collectively punished. A current example is the sub-prime crisis. There may exist certain mortgage businesses or financial insitutions that have little exposure to low-quality loans, and yet they have suffered the same fate as the others in the industry.

Rear-View MIrror Investing: Why Investors Fail To Recognize Value Traps?

The main reason that investors fail to recognize Value Traps is what Buffett calls 'Rear View Mirror Investing' - making investment decisions based on past experience. (See the entire article here). Psychologically we all tend to place significant weight on our past experiences and extrapolate them into the future. This is one of our prime learning mechanisms. If we get food-poisoning from dining at a certain restaurant, we most likely won't return there again. And the converse with positive experiences. Unfortunately, this does not exactly work in the investing game, and is a major cause for failing to recognize a 'Value Trap'. As John Maynard Keynes suggests:

"It is dangerous to apply to the future inductive arguments based on past experience, unless one can distinghuish the broad reasons why past experience was what it was."

There are many examples of businesses that were once dominant players in their industry, and in fact still remain dominant, yet the fundamentals of the industry as a whole have changed.

In my next post, I will provide an example of a great business that looks absurdly cheap, but which, because of massive changes in the industry it is in, make it a 'Value Trap'.

Can you think of the industry that I am referring to? Or a business in such an industry?

Until next time: "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.

VIDEO: Warren Buffett Interview on Fox Business (Oct. 18,2007)

The Fox Business Network which commenced operations last week, hit it off to a great start with this great one-hour interview with Warren Buffett. The interview was conducted by Liz Clayman, formerly of CNBC, who recently joined the network. This was not her first interview with Buffett, and as always, Buffett's humility, candor and wisdom does not disappoint.

Below are some of the video excerpts from the interview, along with the gems that I extracted and some personal thoughts (in blue and tagged with 'IV').

On the Economy (6 Minutes)

"We don't really worry that much about Fed policy, and actually we don't really worry that much about a recession - I hope I live to see a couple recessions."

IV: Value Investors do not pay too much attention to macroeconomic figures such as interest rates, inflation, unemployment figures or the trade balance. They only focus on the fundamentals of the business they are analyzing. As they are long term investors, they know that the businesses they invest in will one day go through a recessionary period. It is inevitable. It is for this reason that when analyzing a company, Value Investors look at the 10-year financial history, and assess how well the business fared during the tougher years.

IV: "I hope I live to see a couple recessions." - This is typical of the Value Investing philosophy - Value Investors love market weakness - as these are the times when the best buying opportunities are available. Incidentally, I recently met with the Managing Director of one of Israel's largest mutual funds businesses, and he was telling me how tough this environment was for him, and how these were dark times for the business. His fund managers are not seeking bargains now, but rather taking the market's lead, and exiting their positions.

"When the tide goes out, you see who's been swimming naked".

IV: This is one of my favorite Buffett quotes - one he has used many times. What he means by this is that it is easy to do well as an investor when the market has been rising and you are buoyed by it. The real test however is when the market suffers significant weakness, and investors flee to 'quality' and defensive companies. One such company is Buffett's Berkshire Hathaway (Ticker:BRK)- which has increased 20% since last July.

On Selling Petrochina (5 Minutes)

"Unfortunately I sold it a little too soon..... we made about $3.5 billion on a $500m investment... I still sold it way too soon.... Charlie would say 'you've done it again!".

IV: This type of comment is vintage Buffett, and which has endeared him to fans and investors around the world. He doesn't speak with bravado declaring 'look I turned $500m into $3.5b but rather - 'I screwed up' - I sold it too soon. It's this type of candid talk which Value Investors look for in the management of businesses they are analyzing.

"It was a 100% decision based on valuation."

"We think about 'how much is it selling for?... 'how much do we think it's worth?"

IV: Value Investors do not try to time the market. They do not seek 'bottoms' or 'tops'. Their investments are based on their estimate of what the entire business is worth.

When asked 'How did [Petrochina] come to your attention? How do you find a stock like that'?

"I sat there in my office, and read an annual report, which fortunately was in English - and it described a very good company..... I sat there and said to myself this company's worth about $100 billion (and at the time it was trading for $35 billion). Now I didn't look at the price first. I looked at the business first, and tried to figure out what its worth - because if I look at the price first I'll get influenced by that. I look at the business first, I try to value it and then I look at the price. If the price is way less than what I just valued it at, I'm going to buy it."

"Other guys read Playboy. I read annual reports....I just read every report I can and figure out whether something is cheap."

IV: Buffett's message is clear. You've got to do the work yourself. No shortcuts. Don't listen to analyst reports or rumors. Do your own independent research. Read the annual reports. Look for what the rest of the market is not seeing.

On Buffett's Best Investment Ever (30 seconds)

IV: Those who know Buffett's history will know already that this investment is GEICO. The story goes that whilst studying at Columbia under his mentor Benjamin Graham, the 21-year old Buffett discovered that Graham was on the Board of GEICO. One Saturday morning, he boarded a train and headed to GEICO's headquarters, which were closed. He found a janitor and pleaded with him to take him to someone who worked for the company. The janitor took him up to the only person in the building at the time - Lorimar Davidson, GEICO's Chief Investment Officer. The young Buffett made enough of an impression on the senior executive that Davidson ended up chatting with him for 5 hours. By the end of that Saturday Buffett recognized GEICO business potential, and why Graham had invested in the business. Soon after Buffett invested 75% of his net worth - $9,000 and sold a couple of years later for a 50% profit. In the late '70's Buffett returned to GEICO, and invested more than $47 million into the company. Today that investment is worth more than $9 billion.

You can read a 1951 analysis of GEICO written by a young Buffett here - "The Security I Like Best" - (thanks to Oded for the link).

Buffett on Bear Stearns (50 seconds)

Buffett on the Yankees (2 mins)

Buffett on Succession (1 min. 41 secs)

"All Three [CEO's] of them are far better than I am".

IV: In my opinion, this is one of the secrets to Buffett's success. Buffett's investment company owns 49 private businesses, that employ more than 217,000 employees. The CEO's that run these businesses are all independently wealthy and do not really need to work. Yet they continue to work under and remain extremely devoted and loyal to Buffett. The reason for this is simple: Buffett refuses to take credit for Berkshire's success. Rather he gives all the credit to his managers, often making statements like "All three are far better than me". This is how you earn long-term loyalty. In contrast, a CEO who takes all the credit for himself will inevitably chase away great executives and managers.

Value Investing Principle #2: Value Investors Are Highly Loss Averse

Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1

- Warren Buffett

Value Investors are not just risk averse – they are loss-averse. Protecting the initial investment always takes priority over the objective of capital growth. I liken this to special operations in the military, where there are always at least 2 primary objectives:

(1) the mission at hand
(2) that all operatives involved in the mission return home safely.

The safety of the soldiers always takes priority over the mission's objectives (at least in the Israel Defense Force, which does not believe in 'suicide missions') and their lives will never be endangered unnecessarily. As such all efforts are made to minimize the risks involved and if it is decided that the risks are too high, then the mission is not approved.

And so it is with Value Investing. Value Investors adopt an attitude of 'better safe than sorry'. They are extremely reluctant to take unnecessary risks. You might as well call them the "Chickens of the Investment World". (However, when the market is driven by fear and panic, or behaves irrationally Value Investors display courage and daring that is extraordinary – more on this later).

This also makes a lot of sense. If you invest in a portfolio of stocks worth $100,000 and a market correction occurs decreasing the value of your investment by 50%, what percentage increase is required to return your portfolio to its initial value? Not 50% as you would intuitively think - but 100%. It now has to move twice as much just to return it to its initial value.

So how do value investors assess risks and minimize the probability of investment loss?

(1) Value Investors demand a Margin of Safety
(2) Value Investors are committed to rigorous investigative research
(3) Value Investors only invest in businesses that they fully understand
(4) Value Investors seek businesses that possess 'Economic Moats'

I will discuss and explain each of these points individually in the next couple of posts.

Shabbat Shalom and Have a Great Weekend,

Avi

Value Investing Principle #1: Value Investors are Voracious Readers

"Formal education will make you a living;
self-education will make you a fortune."
- Jim Rohn

The more that you read,
the more things you will know.
The more that you learn,
the more places you'll go.
- Dr. Seuss

OK OK – I know what you're thinking – you've already read the post last month on the 'Secret to Becoming a Successful Investor' – and you get it - reading is important. I am repeating the message one last time for good reason: As you will come to discover (and I assure you I will point it out), the 'reading principle' is the essential ingredient and a pre-requisite for almost all other Value Investing principles. Choose to ignore it and one stands little chance of successfully adopting and implementing a Value Investing philosophy.

In studying the Value Investing discipline, I quickly recognized the one trait that all successful Value Investors have in common: they are all voracious readers. They are curious individuals by nature, and possess a keen desire to make sense and meaning of the world they live in. It seems that what they read is not confined to the areas of investment and financial markets, but rather spans a diverse range of subjects that include psychology, economics, and science.

Warren Buffett reads 5 newspapers a day, and devotes 75% - 80% of his day just reading. His partner, Charlie Munger observed:

"Warren is one of the best learning machines on this earth. The turtles who outrun the hares are learning machines. If you stop learning in this world, the world rushes right by you. Warren was lucky that he could still learn effectively and build his skills, even after he reached retirement age. Warren’s investing skills have markedly increased since he turned 65. Having watched the whole process with Warren, I can report that if he had stopped with what he knew at earlier points, the record would be a pale shadow of what it is."

On another occasion Munger declared:

"In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time – none. Zero. You'd be amazed at how much Warren reads – and at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out of it."

And neither Buffett nor Munger are exceptions to the rule. Legendary GEICO Co-Chairman, Lou Simpson spends 5-6 hours of his day reading. Mohnish Pabrai and Whitney Tilson, two of the most recent generation of successful value investors are also known to read extensively.

So how does adopting the habit of extensive reading benefit your Value Investing performance? The obvious benefits are:

Investment Idea generation: reading will assist you in recognizing global trends that are unfolding and which can be capitalized on.

Learning Value Investing Rationale: As Mark Twain once said:"History does not repeat itself, but it does rhyme." It is highly beneficial to examine and understand the rationale behind the successful investments made by leading Value Investors. Getting into the minds of such investors will allow you to slowly recognize similar opportunities as they arise.

The Habit of Reading is also the secret weapon that allows the Value Investor to:

• Accurately Assess & Expand one's Circle of Competence
• Add New 'Tools' to your Mental Toolbox
• Improve one's ability to perform independent and critical analysis
• Strengthen one's Investment Conviction: enhancing one's ability and to ignore the experts and the 'consensus crowd' and to develop the courage to adopt contrarian positions.
• Enhance one's ability to maintain a rational outlook when the rest of the market is losing their heads and operating on pure emotions ('fear and greed').
• Adopt a Longer-term Investment Horizon and Ignore Short-term market fluctuations.
• Recognize the Difference between Value and Price.
• Identify and Embrace Change, and Learn and Adapt

I will discuss most of these in greater detail in future posts.

On a Personal Note:

Those who know me well will tell you that books have always been an important facet of my life and have played a formative role on how I view the world. As a child and throughout high school I read avidly; whilst doing my military service I always carried a novel in my kit; and since entering the workforce I have always carried a book, journal or magazine that I could turn to whilst riding or waiting for the bus or train. I have relocated 3 times – to 3 different continents – and each time the important books ('the keepers') have come with me. I can look at any one of these books and tell you where I bought it (or who gave it to me), when I read it and who recommended it. I seem to surround myself with friends that are also readers, and I especially enjoy sharing the knowledge with them. I absolutely love and appreciate great book recommendations.

On first dates and in interviewing employees I often asked 'candidates' about the books they were currently reading or what books had influenced them. I firmly believe that you can tell much about a person's intellectual curiosity from what they are 'feeding their mind'.

I'll sign off with some advice dispensed by Emerson and highly applicable when one meets a successful Value Investor:

"If we encounter a man of rare intellect, we should ask him what books he reads." - Ralph Waldo Emerson

You can view a comprehensive list of books recommended by Warren Buffett and Charlie Munger here.

Other Quotes of Significance:

"What we become depends on what we read after all the professors have finished with us." - Thomas Carlyle

"If a man empties his purse into his head, no one can take it away from him. An investment in knowledge always pays the best interest." - Benjamin Franklin

"A home without books is a body without a soul." - Cicero

"I have often reflected upon the new vistas that reading opened to me. I knew right there in prison that reading had changed forever the course of my life. As I see it today, the ability to read awoke in me some long dormant craving to be mentally alive." - Malcolm X

"It isn't what the book costs; it's what it will cost if you don't read it." – Jim Rohn

"Learning is the beginning of wealth. Learning is the beginning of health. Learning is the beginning of spirituality. Searching and learning is where the miracle process all begins." – Jim Rohn

"Ignorance is not bliss. Ignorance is poverty. Ignorance is devastation. Ignorance is tragedy. And ignorance is illness. It all stems from ignorance." – Jim Rohn

"What you don't know will hurt you." – Jim Rohn

What is Value Investing?

The raison d'etre of this blog is to explore Value Investing opportunities that are abound in Israel. Before I begin to discuss why Israel presents some great value investing opportunities, I think it might be worthwhile looking at what Value Investing is really all about. The next 20 or so posts will examine the different principles that make up Value Investing. After that – a bit about Israel – and then – hopefully dear reader, we will have the tools to begin analyzing some real deals.

So what is Value Investing?

Value Investing is an investment philosophy based on the framework developed and taught by the late Benjamin Graham and practiced by some of the world's most successful investors. The entire framework rests on the belief that the stock market will on occasion behave irrationally, and offer to willing buyers prices that are extremely attractive. In such instances, Value Investors, just like savvy shoppers, will swoop down and pick up 'bargains'.

Numerous research studies have demonstrated that Value Investing has shown superior returns over the long term when compared to other investment philosophies. One such recent study can be viewed here.

While Value Investing is easy to learn (there are no complex formulae), the discipline, focus, patience and extent of research that is required makes it difficult to implement.

Value Investors do not buy stocks; they invest in businesses. The difference between the two is like night and day and must be understood at the onset.

A typical Value Investment possesses all three of the following characteristics:

(1) A Great Business
(2) Run by Great Management
(3) Invested at a Great Price

Finding a business that meets all 3 criteria is not easy. This is why when such an opportunity is located Value Investors tend to invest a 'meaningful amount' of their funds – what Mohnish Pabrai refers to as 'backing up the truck'. This is also why Value Investors tend to be long-term oriented – once we've found 'value', we want to benefit as much as possible from the 'value' we discovered. Value Investors ignore the market and daily-fluctuations of stock price, and rather focus on business fundamentals such as sales, profit margins, cashflow, debt levels and inventory management.

Pretty simple huh? No fancy-shmancy PhD-level statistics and no Greek letters – just plain-old common sense.

You probably now have some / all of the following questions on your mind:

(1) What do Value Investors define as a great business?
(2) How do Value Investors locate great businesses?
(3) How do Value Investors recognize 'great' management?
(4) What do Value Investors consider a 'great' price

All these questions – and more - will be addressed in the coming posts.

I'll sign off with a relevant passage from Warren Buffett's 1992 Berkshire Hathaway Letter to Shareholders:

"We think the very term "value investing" is redundant. 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).

Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase."

The Secret to Becoming a Great Investor

Greetings dear reader!

As I last promised I am about to reveal to you the Secret to Becoming a Great Investor. But before I do, allow me to address a question of no less importance:

"Why do most individuals have little chance of becoming great investors?"

To answer this, I would like to take you back 900 years (indulge me, I beg you) and introduce you to one of Judaism's foremost philosophers - Rabbi Moses Maimonides. Now this chap was not your average run-of-the-mill Rabbi. Fluent in Arabic, Spanish, Greek and Hebrew, he was learned in Jewish mysticism, the exact sciences, medicine, astronomy, Greek philosophy and served as the Royal Physician in Egypt. Like I said a pretty cool guy.

Maimoides authored a text called 'The Guide to The Perplexed' (or 'Moreh Nevuhim') - an esoteric work that deals with Kabbalah and Jewish Mysticism. Not the easiest of books to read (Trust me, I received a copy on my 19th birthday from my best friend - and I still haven't finished it!). I digress. In Chapter 34, he explains why the average individual will never be able to grasp the secrets of Jewish Mysticicm - of Kabbalah. 900 years later, his explanation also applies to the question I posed - "Why do most individuals have little chance of becoming great investors?". I provide a loose translation below:

"Preparatory studies are of long duration and Man by his nature is focused on the end result, finds these tedious and is reluctant to engage in them. Know this, if a man were able to reach a worthy goal, without any preparatory studies, such studies would be futile and a waste of time. Now suppose you awaken any person, even the most simple, and say to him 'Do you not wish to understand the nature of the heavens, their number and their form; what beings are contained in them; what the angels are; how the creation of the whole world took place; what is its purpose, and what is the relation of its various parts to each other; what is the nature of the soul; how it enters the body; whether it has an independent existence, and if so, how it can exist independently of the body; He would undoubtedly say "Yes," and show a natural desire for the true knowledge of these things. But he would wish that this desire be satisfied and to attain such knowledge by only listening to a few words. Ask him however to interrupt his usual pursuits for a week, and devote his time to obtaining such knowledge, and he would not do it. He would rather be satisfied with simple imaginary and misleading notions and would refuse to believe that there is anything that requires extensive investigative learning."

Like I said - not easy reading. Simply put what the good Rabbi is telling us is that the average person wishes to know the 'secrets of the universe' but is unwilling to pay the price – and devote the long hours of study required. And that is why 'Hidden Knowledge' is not available to the
masses – it's not that it's physically hidden, but that people are not willing to apply themselves to the learning.

Ask anyone if they want to be as successful as Warren Buffett and they will reply in an instant 'Hell – yeah!' Tell them however, that the price they must pay for such success is that they are required to expand their breadth of knowledge, begin reading books (non-fiction), that they must teach themselves how to read financial statements and read tens of annual reports a month, and most will look sideways uneasily and immediately excuse themselves, muttering something about returning late DVD's or forgetting to feed the dog.

And so it is with Value Investing. It is not difficult and not rocket-science. In fact it's really quite simple. There is enough free material available on the internet that a person who willingly sacrifices time in front of the TV, and instead devotes several hours a week to research and learning, will in no time be viewing the stock market in a similar light to Warren Buffett.

And now for the Secret to becoming a great investor:

In the 2007 Berkshire Hathaway Annual Shareholders' Meeting, a 17-year old asked Warren Buffett:

'What should I do to become a great investor?'

Buffett replied:

"Read everything you can…. When I was ten I'd already read every book in the Omaha Public Library with the word 'finance' in the title".

In my next post - "The Value Investors Library" - I will provide a list of books that have been recommended by Warren Buffett, and his partner Charlie Munger, and others which in my opinion are essential if you wish to expand your investment horizons.

Signing off for now - "May you possess the wisdom to see what the market does not, and the courage to act on it.

* It may be no coincidence that the root of Maimonides' name ('Maimon - or M-M-N) is also 'money' or 'finance'.

** Thanks to Oded for the 'Perplexed' quote.

The Relationship between Gratitude & Value Investing

I am continuously amazed at the extent of humility that I see in the value investors that I so much admire and learn from. When one reads / hears their words, one gets the distinct impression that they are genuinely aware they couldn't have been so successful without the assistance of others. They are forever declaring how lucky they are, how fortunate and grateful they are etc. They do not attempt to convince their investors that they can out-guess or time the market, and they are able to say 'I have no idea'. Their humor is self-deprecating and they do no hesitate in admitting their investment errors, or their infallibility.

Here's some examples of Warren Buffett's humility and gratitude:

"Charlie and I are extraordinarily lucky. We were born in America; had terrific parents who saw that we got good educations; have enjoyed wonderful families and great health; and came equipped with a “business” gene that allows us to prosper in a manner hugely disproportionate to other people who contribute as much or more to our society’s well-being. Moreover, we have long had jobs that we love, in which we are helped every day in countless ways by talented and cheerful associates. No wonder we tapdance to work."

"The odds for me to have been born in the US were 1 in 50. I won the ovarian lottery. If I had been born in Bangladesh, the chances are that I would not have had such great opportunity. Bill Gates says that if I had been born 1,000 years ago, I would have been some animal's lunch."

"Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact Charlie had on me. It took a powerful force to move me on from Graham's limiting views. It was the power of Charlie's mind. He expanded my horizons."

It occurred to me that there is a direct relationship between one's level of gratitude and one's ability to succeed as a Value Investor. But before I share this observation, I think I should first give thanks myself:

First and Foremost, I am extremely thankful for:

My wife Einat, who allows me to be me. From the onset you have been supportive of and willing to join me in doing things differently, in not being pressured with what is conventionally expected of us, and of holding a long term view. Our children could not want for a more amazing mother. I could not want for a more amazing partner. And you're one hell of a cook!

My daughters – Alma and Shira – you are my greatest teachers. I am in constant awe of you both, and of the role of parent. I can only hope I won't let you down.

My parents – who placed education above all. By example, you taught us the value of a strong work ethic and the importance of integrity.

And especially to my father, who put that first book 'How to Buy Stocks' (by Louis Engel) into my hands at age 12. I still have that paperback copy (1977 edition), its pages tattered and the color of a macchiato. Since then, I have been captivated by financial markets, and constantly seek to outwit 'the crowd'.

I am also very thankful to (in no particular order):

Oded Kraizel – My very own 'abominable no-man', he is the real impetus behind this blog. In the short time that I have known him, he has had a major positive influence. He has an eagle-eye when it comes to financial statement analysis, despite having no formal accounting training and is a committed Value Investor. And he makes the world's best Tahini!

Tony Holley – who first struck up a conversation with me at a bus stop in Sydney's financial district, and then proceeded to explain how my methods for investment analysis were all wrong. In the space of a couple of weeks you placed The Intelligent Investor into my hands, introduced me to the world of Buffett, and convinced me to abandon technical analysis and adopt the precepts of Value Investing. Ever since then, you continuously ensure that I am reading great books – even when the distance between us is thousands of miles.

Larry Shein – who was the raw definition of courage. I am forever grateful for the laughter and hours of philosophy, and for the chance to say goodbye.

Lisa Wade – who despite living on a different continent to me for most of the last 15 years, remains one of my closest friends. She was the first person that suggested that I become an equity analyst.

Hamish Petrie – who I have had the wildest of times with, and who dragged me from Sydney to San Francisco to set up our first company. He is one of the greatest salesmen I know. Watch out for his close – it's lethal!

Danny Marcus – who is committed to remaining young at heart. I miss diving with him, his friendship and humor, his worldly wisdom, and his insistence that I learn from his experiences.

Dave Shein, Nathan Cher & ComTech Communications - my years at ComTech had a major influence in shaping the way I view business strategy, management structures and accounting principles. I was the company's 4th employee, working part-time whilst still in highschool, making and testing networking cables in the Erskine Street basement. I financed my university years by working in the company's dispatch center and later in the PROM testing lab, before becoming the company's assistant accountant. There is much to write about what I learned at ComTech, and I hope to devote an entire post to it.

Prof. Yehezkel Dror – Recipient of the Israel Prize. I was fortunate to work under his steadfast tutelage during my first years in Israel. I will be forever grateful to him for introducing me to the world of futurist studies, and long-term scenario and trend analysis.

Shlomo Nir – who is always there and generous with advice on all matters, from parenting and marriage, to car engines and problems with the plumbing.

Illana McKinstry and Dezy Devai – the twin sisters that have been like my own. They have been there, unconditionally, for as far back as I can remember.

Paul Israel & The Australia-Israel Chamber of Commerce - for his untiring dedication to promoting bilateral trade between the 2 countries. Onya Paul!

Jon Boock and the Israel Funds Observer team - In an industry that does not possess a modicum of a long-term perspective, they are the lone voice committed to bringing to the Israeli Market a level of rationality and depth of analysis that did not exist previously. Watch for their analysis and commentaries - they will no doubt separate the wheat from the chaff!

Oren Shemesh – because you can't be lucky enough to have great neighbors!

My students - past and present - you are a constant source of challenge, fulfillment, learning and inspiration.

And I could not see what I see, nor do what I do, were it not for my teachers:

I am grateful to my teachers: Warren Buffett, Charlie Munger, Benjamin Graham, Philip Fisher, Mohnish Pabrai, and Joel Greenblatt.

I have yet to come face to face with any of you, and we have never exchanged a word, but you continue to share your knowledge generously. You answer questions that are too intelligent for me to pose, and you have blazed a bright and burning trail that has been easy to follow.

You see, I am really nothing more than the sum total of the cumulative influences of the individuals that I have deeply associated with, and from the books that I have read. The only credit I grant myself is in surrounding myself with people far more intelligent and talented than I am, my willingness to be open to new ideas, and for earning their friendship and affection. When you surround yourself with people that you admire and that you can learn from, you are left with little choice but to improve yourself. They force you to be the best you can be.

The relationship between Gratitude and Successful Value Investing

It is easy to feel genuinely grateful for one's situation when one is critically honest with oneself, and is not tainted by ego. One views things more clearly and has a greater appreciation of all the factors that have lead to the present moment.

Successful Value Investing begins with the ability to appraise an asset accurately – to see it clearly for what it is – without all the market noise. To appreciate something is to know its worth or value – to appraise it accurately - and so dear reader, it should be no surprise that the world's most successful value investors are also the most grateful.

You see, the process of wealth generation seems to begin by realizing how wealthy we already are. I think this is what Rabbi Ben Zoma meant when he said: "Who is rich? He who is happy with that he has." Pirkei Avot (Ethics of the Fathers). It is also an interesting coincidence that this same quote appears in Benjamin Franklin's Poor Richard's Almanack. Benjamin Franklin is Charlie Munger's hero. Charlie is Warren Buffett's partner.

A Gratitude Meditation

If you woke up this morning with more health than illness, you are more blessed than the million who will not survive this week.

If you have never experienced the danger of battle, the loneliness of imprisonment, the agony of torture, or the pangs of starvation, you are ahead of 500 million people in the world.

If you can attend a church / synagogue meeting without fear of harrassment, arrest, torture or death, you are more blessed than 3 billion people in the world.

If you have food in the refrigerator, clothes on your back, a roof over your head, and a place to sleep, you are richer than 75% of this world.

If you have money in the bank, in your wallet, and spare change in a dish someplace, you are among the top 8% of the world's wealthy.

If you have ever made a phone call, you are ahead of 50% of the world population that never has.

And if you are reading this blog - and have access to the internet then you are ahead of 90% of the world population that does not have access to the internet.

Next Post - "Who is this Warren Buffett Dude Anyway?"

Signing off for now: "May you always possess the wisdom to see what the market does not, and the courage to act on it."

Israel Value Investing Blog Launch:Happy 77th Birthday Warren Buffett!

Greetings dear visitor and welcome to Israel Value Investing!

The very first post of Israel Value Investing is brought to you by the letters, 'W', 'E' & 'B' and the number '7'.

I chose to launch this post today – of all days – because it was on this day 77 years ago that we were fortunate enough to have one of history's most successful long-term investors join us.

Happy 77th Birthday Warren Edward Buffett – it's good to have you with us!

We wish you long-life – or as they say in the Jewish tradition – 'Until 120'.

The Israel Value Investing blog is dedicated first and foremost to Warren Buffett.

I have little doubt that this blog would exist if it were not for the man. One cannot generate content relating to Value Investing without referring to Warren Buffett or quoting him constantly (and - as you will see - there’s a lot worth quoting!). The contribution that he has made to the Value Investing philosophy is without measure. Through his Annual Letters to Shareholders, 6-hour long Q & A sessions at the Berkshire Annual Shareholders meeting, and hundreds of interviews, Buffett has generously shared with the world his views, philosophies and investment strategies. Anyone who had the common sense to recognize the eternal truths behind his views will not hesitate to tell you that he is a better investor, CEO, parent, and human being because of them. Close to 20 books have been written about Buffett and hundreds of media articles and interviews. It is little wonder that a cult-following has emerged, hanging off every word and every investment move.

If you have not heard about Warren Buffett, or know little about him – not to worry – I plan to dedicate an entire post to him in the coming days, and will no doubt refer to him in future posts.

The Israel Value Investing blog is where I get to combine my passion for value investing, Warren Buffett (not that kind of passion!), Israel and writing. It is here where I hope to analyze and discuss Value Investing opportunities that present themselves in Israel. It also serves as a medium to address the endless questions from family, friends, and students. Questions like:

Isn’t the stock market risky?

Shouldn’t you invest in real estate? Real estate is a much safer investment than the stock market?

If you’re so good at picking stocks why don’t you use options?

If you’re so good at picking stocks why is such a large portion of your portfolio in cash or treasuries?

Shouldn’t you have a more diversified portfolio?

Shouldn’t you exit the market now, the experts are saying that it is overpriced and heading for a crash?

Who is this Warren Buffett dude that you are endlessly quoting?

Why are you always reading?

In the Israel Value Investing blog you can expect to find posts relating to:

(i) Value Investing: What it is, what are its tenets, why it is considered the most successful long term strategy for investing in the stock market, who are its champions, why so few people have adopted it and more.

(ii) Israel: Why Value Investors around the world should be paying attentionto the Israeli economy and Israeli corporations.

(iii) Value Investing Opportunities in Israel: I intend to scour the Israeli and foreign markets for Israeli corporations that represent excellent 'value' - great companies at great prices.

(iv) Value Investing Opportunities that have nothing to do with Israel: I also intend to take a look at other value investing ideas which may not necessarily have anything to do with Israel.

(v) The Key Drivers that will significantly affect our lives: I hope to refer to the global ‘mega-trends’ that will most likely affect global business in the coming decades.

In the coming posts I hope to share with you:

• Who is this Warren Buffett dude anyway?


• Why possessing the habit of gratefulness will make you a better investor.


• How Buffett and Maimonides think alike and what they both believe is the secret to becoming a great investor.


• The foundation principles of Value Investing.

• Why Value Investors should pay close attention to the Israeli economy and Israeli corporations.

And much much more.

Before I start posting on Value Investing opportunities in the Israeli market, I am going to dedicate a series of posts to the underlying principles of Value Investing - for the unitiated.

For those readers that are already familiar with Value Investing, I ask for your patience while I bring the uninitiated up to speed, and look forward to your own contributions.

Next Post - "The Relationship between Gratitude & Value Investing"

Signing off for now: "May you always possess the wisdom to see what the market does not, and the courage to act on it."