Final Post

Valued Readers (and Readers of Value):

As you may have noticed, it has been close to 90 days since my last post.
Corporate clients, industry license exams, and a 'blood-in-the-streets' market environment have kept me away from my ramblings.

It also seems that this is going to be my final post for the foreseeable future. I was recently approached by Israel's leading bank, and invited to join their managerial ranks. As I have decided to accept their invitation, Israel Value Investing might be viewed as a conflict of interest, and as such, I have little choice but to bid you adieu.

As always, may you possess the wisdom to see what the market does not, and the courage to act on it.

Avi Ifergan
January 2008

Value Investing Principle #4: Value Investors are Futurists

My interest is in the Future because I am going to spend the rest of my life there. - Charles Kettering

In a recent post on Value Traps, I promised that I would offer what is the #1 way to hone one's ability to recognize a 'value trap'. The answer's simple: Become a 'Futurist'.

Before I tell you what a Futurist is, allow me to briefly explain how I stumbled across Futurism.

In 2001, and from the furthest city in the world from Jerusalem – Sydney – I watched intently (and with great disapproval) at how the political and social situation in Israel was unfolding. I couldn't bear being a distant sideline observer, and wanted to become more involved in Israeli 'policy-shaping'. And so, in the first half of that year, I left Australia and abandoned the world of entrepreneurialism, venture capital and financial markets to begin a new career path.

Soon after arriving in Israel, I found myself working under Professor Yehezkel Dror, Israel Prize Recipient, and one of the country's foremost thinkers and policy-planners. With his guidance I co-wrote the "The External Mirrors of Israel: A Comparative study of Israel and it's Neighbors" which was presented at the 2001 Herzliya Conference.

Dror introduced me to a field which immediately appealed to my love of history and sense of curiosity: Futurist Studies or Futurism. As I immersed myself in the reading material, I quickly recognized the similarities and importance of this field to my former profession – and to Value Investing.

So what's a Futurist?

Imagine that we're all passengers on one of the ships on Columbus' fleet. The Futurist's role is to sit in the little 'lookout perch' (called a 'crow's nest) at the top of the ship's mast and to scan the horizon in search of possible danger such as hidden reefs, enemy ships, or changing weather patterns. In fact, anything that might affect the ship's course, mission or safety. He relays all relevant information to the ship's captain and crew, who take such information with the required seriousness, and they respond as needed.

OK – enough with the metaphor. Adopting a multidisciplinary perspective, Futurists examine various long term trends with the hope of identifying the threats and opportunities that face all of mankind in the future. Futurists study and seek patterns of 'change'. To see what I mean, take a look at what I believe is one of the most eye-opening videos on YouTube today:

Futurists pose the question: "how will our lives be different 25 (or more) years from now?" Areas of interest include:

- Demographics: How do the trends of living longer, getting married later and having fewer children affect society, the labor force, social welfare, taxes, etc.

- Religion: What's happening in the world's major religions?

- Education: How are learning habits changing?

- Health: What are the trends and developments regarding health, diseases, nutrition, obesity, medication and health care?

- Work Lives: How is our work lives changing? Are we working more or less than previous generations? How does this affect our family units, education and social values?

- Wealth: Which professions and industries are valued the most by modern society – and why?

- Recreation: What are the trends with regards to how much free time we enjoy and how we choose to spend it?

- Environment and Ecology: What are the environmental and ecological challenges that we have created for ourselves – and how can they be addressed?

- Science & Technology: What are the new frontiers? Space? DNA engineering? New forms of planetary and inter-planetary travel. New forms of communication and knowledge-sharing.

- World Conflicts: How have global conflicts changed in the past century?

Examining such issues, futurists most of all seek to identify 'disruptive trends' or 'ruptures' in history. These are changes so significant that Futurists predict they will have a major impact on our future lives.

Back to the metaphor: unlike a ship's captain or crew whom listens and acts according to what the ship's lookout sees, mankind and its leaders do not have the same inclination to heed futurist thought. Futurists are sometimes ignored and often ridiculed, as states, world leaders, industries, and multinational corporations continue to focus on individual short-term interests over collective long-term security.

Ironically, if a Futurist succeeds in his role as a 'policy shaper', then the leaders he works for will have found ways to navigate around the threats that he identified, and his predictions will never eventuate.

The interesting thing about 'futurist thinking' is that when a person is revealed to it, they are usually not surprised at its findings. This is because the trends discussed are happening before our very eyes, and happening ever so slowly that we fail to ask the important question: 'So What?' We usually know what's going on – but fail to recognize the long-term implications that they have on our lives. Perhaps this is because we are so focused with the short term day-to-day distractions that lie immediately before us that we rarely manage to lift our heads and set our eyes on the horizon? I don't know. What I do know however is that if we are unable to look to the distance, we should at least pay some attention to those that can.

So how does this bear any relevance to Value Investors?

Futurist thinking and Value Investing go hand in hand. Value Investors are by nature, long-term oriented, and seek to gain understanding on 'what's going on?' from the long perspective. Such an understanding allows Value Investors to identify what will be important markets and industries in the future and what industries are waning and should be avoided. (Take a look at my recent post on Gannett to see how recognizing the changing trends on how we consume news would have prevented you from erringly invested in a 'value trap'.)

When reading Berkshire Hathaway Annual reports and Letters to Shareholders one gets the distinct impression that Buffett is a Futurist at heart. His writings also bear the tone of a ship's lookout that is desperately trying to get the attention and warn the captain and crew below. Just take a look at these two recent examples:

America's Growing Trade Deficit is Selling the Nation Out from Under Us. Here's a Way to Fix the Problem - and We Need to Do It Now! - by Warren Buffett, Fortune Magazine, October 6, 2004

What Worries Warren - by Warren Buffett, Fortune Magazine, March 3, 2003

In the coming posts I intend to introduce some Futurist thought, although I doubt that any of it will be new to you. In these, I hope to answer the 'So What?' question by pointing to what I believe are the main long term drivers of the future and the Value Investing opportunities that we can patiently lie in ambush for.

Some Additional Futurist Resources

- The Futurists Top 10 Forecasts for 2008

- The World Futurist Society

- The Futurist Magazine

Recommended Futurist Reading:

(Tip: Hover your mouse over the title of the book for additional information on it).

Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics

Revolutionary Wealth: How it will be created and how it will change our lives

The Third Wave

Future Shock

Powershift: Knowledge, Wealth, and Power at the Edge of the 21st Century

Seeing What's Next: Using Theories of Innovation to Predict Industry Change

Medici Effect: What Elephants and Epidemics Can Teach Us About Innovation

The Next Great Bubble Boom: How to Profit from the Greatest Boom in History: 2006-2010

The Roaring 2000s: Building The Wealth And Lifestyle You Desire In The Greatest Boom In History
Guns, Germs, and Steel: The Fates of Human Societies

Collapse: How Societies Choose to Fail or Succeed

The Third Chimpanzee: The Evolution and Future of the Human Animal (P.S.)

The Art of the Long View: Planning for the Future in an Uncertain World

Inevitable Surprises: Thinking Ahead in a Time of Turbulence

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.

Israel: World MVP

I've been meaning to write a post on why value investors should take a serious look at Israeli companies, and why Warren Buffett made his first invesment outside of the US in Israel. But someone beat me to it.

Pat Boone, the legendary music artist penned the following column last week on WorldNetDaily. I couldn't have written it better myself.

Israel, World MVP
Posted: October 27, 20071:00 a.m. Eastern

As you read these words, I'm in Israel. My wife, sister, brother and his wife, two of our granddaughters, a host of friends and their friends … all 38 of us have literally walked into the pages of the Bible.

This is perhaps my 12th trip (I've lost count), but the impact, the emotional and spiritual shivers I always experience, have never lessened. It's one thing to read the whole Bible cover to cover, as I do every year, but actually to walk around on the very sites of the events described so accurately in that book is truly soul shaking.

We'll stand, physically, where David picked out the stone with which he felled the giant Goliath; we'll climb up the rocky ravine to the cave of Ein Gedi, where David hid from King Saul; we'll look out over the vast plain of Megiddo, where the cataclysmic battle of Armageddon will take place; we'll buy sodas at Jericho, still inhabited, though without the wall that used to surround it; we'll look up at Mount Nebo, from which Moses gazed at the Promised Land he'd never enter; we'll read aloud the Sermon on the Mount in the natural hillside amphitheater where Jesus first spoke those words; some of our group will be baptized in the Jordan River, close to the place where Jesus Himself was baptized by John the Baptist; we'll visit the hill called Golgotha, the "place of the skull" where He was crucified between two thieves – and we'll also spend time looking into the hole in the wall where His body was laid and celebrate the fact that it's empty, as it has been since the stone rolled away at dawn on the third day.

All these things, and hundreds more, actually happened in Israel, just as the Bible recounts. And one of the most amazing things is the seemingly impossible promise God made to Abraham, an unknown sheep-herding nomad from Ur of the Chaldeans, and repeated to Isaac and Jacob: "In your seed (through your descendents) all the nations of the earth will be blessed." How could this possibly be? But it has literally happened, and extravagantly!

I've written here before about the innumerable contributions Israelis have made to the world, in virtually every category – literature, chemistry, medicine, physics, economics, every science and technology, Internet and communication, and efforts for world peace. Twenty-one perceont of all Nobel Prize winners worldwide have been Jews! The list of achievements and astounding contributions is endless.

Every day, virtually every person in the civilized world benefits from these contributions, in areas relating to food, medicine, overall health, knowledge, security, great literature (including of course the Bible) and music – almost everything that we think of as "quality of life." It has long been established, and is obvious on its face, that in every nation motivated and influenced by Judeo/Christian principles, the population has prospered and the culture flourished. The reverse is also true: Societies and cultures that have rejected and even opposed those principles have lagged behind, even drastically suffered in all the same areas and quality of life.

And the pace has greatly quickened in the last several decades. Consider: Israel is the 100th-smallest country, with less than 1/1000th of the world's population – but its $100 billion economy is larger than all of its immediate neighbors combined. It also has the fourth-largest air force in the world (after the U.S., Russia and China), with over 250 F-16s and very powerful weapons – to defend itself against the announced and very serious threats of some of those same neighbors.

Out of its own necessity, but also to help all peaceful societies, Israel designed the airline industry's most impenetrable flight security. U.S. officials now look to Israel for advice and technology in handling airborne security threats. Fly anywhere safely lately? Thank Israel. (My family and I do that every day, sometimes every hour, here in Israel.)

Look further: Israel has the highest ratio of university degrees to its population in the world; she produces more scientific papers per capita than any other nation by a large margin – 109 per 1,000 people – as well as one of the highest per capita rates of patents filed. With more than 3,000 high-tech companies and startups, Israel has the highest concentration of high-tech companies in the world – apart from the Silicon Valley, USA.

How does this matter to you and me, and every other citizen in the world of the 21st century? The cell phone was developed in Israel by Israelis with Motorola, which has its largest development center in Israel. Most of Windows NT and XP operating systems were developed by Microsoft-Israel. The Pentium MMX chip technology was designed in Israel at Intel, and both the Pentium-4 microprocessor and the Centrino processor were entirely designed, developed, and produced in Israel. Voice-mail technology and AOL's Instant Messenger were developed by young Israelis.

Medical technologies, diagnostics, pharmaceuticals and treatments that offer healing in almost every area of disease and disability are just too many to list here. But let's note that when Stephen Hawking, generally considered to be the most brilliant thinker on the planet, visited Israel recently, he shared his deep musings with scientists, students and even the prime minister. But the world's most renowned victim of ALS, or Lou Gehrig's Disease, also learned something: Due to the Israeli ALS Association's advanced work in both embryonic and adult stem cell research, as well as its proven track record with neuro-degenerative diseases, the Israeli research community is well on its way to finding a treatment for this fatal disease affecting 30,000 Americans and tens of thousands worldwide!

Israel's Given-Imaging has developed the first ingestible video camera, so small it fits inside a pill; it's used to view the small intestine from the inside, to detect cancer and digestive disorders. And other Israeli researchers have developed a new device that directly helps the heart pump blood – an innovation with the potential to save lives among those with heart failure. There's also a revolutionary new acne treatment, the Clear Light device, that causes acne bacteria to self-destruct – without damaging surrounding skin or tissue.

An Israeli company was the first to develop and install a large-scale, fully functional solar electricity generating plant, in Southern California's Mojave Desert. What does that portend for an energy-guzzling, oil-stained world?

Truly, the accomplishments – too numerous and complex to list here – are staggering; I've only scratched the surface, and I've already noted the pace is accelerating exponentially. Israel is just getting started. Proportionately, no other country in the world can match her creativity and her massive contributions to the world's standard of living – not even the United States.

And I haven't even mentioned that the three largest religious faiths in the world are expecting the appearance soon of a Messiah – a Savior to all mankind, at least to those who will acknowledge and receive Him – in ultimate fulfillment of the incredible promise made to Abraham, "Through your seed will all the families of the earth be blessed."

In this game we play on earth, called life, though many players have contributed great things, the MVP – the Most Valuable Player – has been clearly revealed.

It is Israel.

Pat Boone, descendant of the legendary pioneer Daniel Boone, has been a top-selling recording artist, the star of his own hit TV series, a movie star, a Broadway headliner, and a best-selling author in a career that has spanned half a century. During the classic rock & roll era of the 1950s, he sold more records than any artist except Elvis Presley.

Is Gannett Co. (GCI) A Value Bargain or Value Trap?

In my last post I introduced the concept of 'Value Traps' - where the business looks like it is a 'bargain', but there is in fact a justified reason behind the market's discount.

There are some industries that experience significant upheaval and change as a result of a disruptive technology or change in consumer behavior. The erosion of economic fundamentals that occurs will impact a Value Investor's estimation of a business' intrinsic value.

An immediate example that comes to mind is the newspaper and print media industry. Let's see what Buffett has to say on the matter:

From the 1991 Berkshire Hathaway Letters to Shareholders:

"We have a significant investment in media - both through our direct ownership of Buffalo News and our shareholdings in The Washington Post Company and Capital Cities/ABC - and the intrinsic value of this investment has declined materially because of the secular transformation that the industry is experiencing."

And again in his 2006 Letter:

"And fundamentals are definitely eroding in the newspaper industry, a trend that has caused the profits of our Buffalo News to decline. The skid will almost certainly continue."

And for those who might believe that each newspaper's website will substitute for any lost revenue Buffett continues:

"True, we have the leading online news operation in Buffalo, and it will continue to attract more viewers and ads. However, the economic potential of a newspaper internet site – given the many alternative sources of information and entertainment that are free and only a click away – is at best a small fraction of that existing in the past for a print newspaper facing no competition."

And now for a real-life example: Gannett Co [Ticker: GCI]. Founded in 1906, Gannett's operations are primarily in the US and UK, and include 90 daily newspapers, 1,000 non-daily publications as well as 23 television stations that reach an estimated 20 million viewers in the US.

In order to establish an estimate of Gannett's Intrinsic Value, I will first need to obtain an estimate for free cash flow. Going to last year's Cash flow Statement. I take Net Income, add Depreciation and subtract Capital expenditure. Free Cash flow comes out to be around $1.24 billion.

Now comes the tricky part: estimating future earnings growth. I go to analyst consensus earnings - here. Scrolling down to the bottom of the page I see that analysts are expecting average annual earnings growth for the next 5 years of 4.35%.

I now plug both these figures into a simple DCF calculation, use a 10% discount rate, divide by the total number of shares outstanding and get an intrinsic value of about $64 per share - a 55% discount to current market price. On the face of things - this seems like a bargain, right?

What's wrong here? Going back to Yahoo's analysts consensus earnings estimates, I take a look at earnings growth for the last 5 years - an average of just under 2%. Many studies have shown that analysts tend to be optimistic in their assumptions - and here we see it in action. The last 5 years earnings growth was barely 2%, and analysts believe that in the next 5 it'll be double that? I doubt it.

What happens if I plug in 0% growth for the next 10 years into my DCF - in other words the industry remains stagnant and goes nowhere. I come up with an intrinsic value of $44 - still a 7% discount to today's price. In other words, contrary to analyst consensus, the market believes that the industry will experience continued erosion.

Gannett looks like a bargain, but a Value Investor who looks past the numbers, takes analyst estimates with a pinch of salt, and investigates what's happening in the industry may come to a completely different conclusion.

In my next post on Value Investing Principle #4, I will reveal what I believe is the best way to spot a 'Value Trap'.

Please read the Legal Disclaimer.

Disclosure: Author does not hold a position in GCI.

Avi Ifergan is the Managing Partner of Israel Value Funds (www.israelvalue.com) an Israel-based investment partnership that follows a disciplined and long term oriented Value Investing approach, with a primary focus on Israeli public companies. Avi is a former equity analyst, corporate advisor and serial entrepreneur. These days he spends his time teaching economics at a major Israeli university and seeking value investing opportunities. He very much appreciates your feedback at avi@israelvalue.com.

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 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".