Value Investing Flavors

I ran across this article, Value Investor or Value Pretender: Which Are You?, by who puts out The Manual of Ideas, along with Oliver Mihaljevic.  I appreciate what they do — you can learn a lot from their organization.

I told him that I was going to write this, and he said to me:

The piece was meant tongue-in-cheek but feel free to rip it apart :)

I will rip it apart, but gently, because every point he made is mostly true for value investors, but there are variations in the way that value investors operate, so you can do some of the things he says you can’t do, and still be a value investor — what matters is how you implement them.

There will be more parts to my “Education of a Risk Manager” series, and one of them will deal with all of the different managers that I met, and how much they varied in terms of what they thought were factors that mattered.

Thus, as I developed my own theories of value investing, I considered the range of opinion, and realized that there is a single model for value investing, but that it is complex enough that different parties use different approximations of the full model, and those approximations do better and worse in different environments.

Like a David Letterman-style Top 10 list, John Mihaljevic listed and described things that made you a value pretender.  Time to go through them:

Reason #10: You invest based on chart patterns

I don’t use chart patterns, but I do use momentum both positively & negatively.  There is decent evidence that investors are slow to react to new information, and so stocks with strong price momentum over 200 days tend to do better.  There is some evidence where there is lousy price momentum over a 4-year period, that things tend to mean-revert.

Granted, there is a tendency among some value investors to troll the 52-week low list.  I like doing that too, but you have to be careful, because maybe you are missing something that cleverer investors know.  The same would be true of short interest figures.  Whenever I see one of my stocks gain a high short interest ratio (shares sold short / volume, or % of mkt cap sold short), I do a review to see what I don’t know.  That’s why I am not afraid of the high level of shorting on Stancorp Financial.  This is a conservatively run firm that manages risk up front.  Even though disability claims rise when unemployment is high, they underwrite better than most of the industry.

There have been some very successful value plus momentum investors.  The balance is tricky, but blending two of the most powerful anomalies does bear fruit.

Reason #9: You assume multiple expansion in your investment theses

I never assume that, but if you are buying them “safe and cheap,” you often do get multiple expansion.  The challenge is figuring out where things are less bad then the implied opinion of the depressed valuation.

Reason #8: You try to figure out how a company will do vis-à-vis quarterly EPS estimates

I don’t do that either, but I have known some value managers that incorporate prior earnings surprise data, because past earnings surprises are correlated with future surprises.  Often, near the the turnaround point for a company’s stock, there are some earnings surprises.

Reason #7: You base your decisions on analyst recommendations

I have few arguments with this, except negatively.  Sell-side analysts are trailing indicators.  I like buying companies where the sell-side is negative, but not very negative.  With very negative opinion, there are often reasons to stay away, unless you possess specific knowledge that the sell-side analysts do not have.

Reason #6: You use P/E to Growth (PEG) as a key valuation metric

I’m sorry, but PEG works, if indeed you have the growth rate right, which is a challenge.  I do try to analyze sustainable competitive advantage for the firms that I own.  That often leads to growth.  Now I am a growth skeptic, so it takes a lot to make me pay up for growth, but occasionally I will do so, when the PEG is low enough.

Reason #5: You use EBITDA as a measure of cash flow

EBITDA is not cash flow from operations, or free cash flow, but it is a valuable figure in value investing when it divides into Enterprise Value (Value of Debt + Value of Stock – Cash).  Low ratios of Enterprise value divided by EBITDA are very effective at identifying promising investments — it indicates cheap assets, and in a time when M&A is hot, it can really pay off.

Reason #4: You would worry about your portfolio if the market closed for a year

I could live with the market closed, but there are advantages to having it open.  With any given stock, there are times in a year to increase or reduce exposure — if you have a firm idea of what the firm is worth, you can buy more during dips, and sell a little into strong rallies.  Short term (one month) stock price movements are fickle, and commonly reverse.

Reason #3: You make investment decisions based on the activity or tips of others

But Manual of Ideas tracks the 13F filings of great investors.  I get good ideas from the best investors also, but you have to do your own research.  Many bright investors chat with each other, and I had many occasions at the hedge fund that I worked for where I disagreed with a friend of the boss.  I was right more often than I was wrong.

Perhaps a better way to phrase it is “choose your idea generators wisely, but do your own research as well.”

Reason #2: Your investment process centers on the market opportunity

This is largely true, but when I know a industry or sector is in horrible shape, I often buy the strongest name in the industry, realizing that they will do well as the competition dies, and they don’t.  Also, there are times when few recognize that pricing power has shifted, and it is time to take a position on a misunderstood industry that is about to grow faster than expected.  Particularly with cyclical companies this idea can be promising.

The same applies to countries where the markets are washed out.  Don’t try to time the bottom, but when a country is cheap, buy a promising/safe company in the country after things have turned up for 100 days or so.

Reason #1: Your investment theses do not reference the stock price

At some points, I like to own companies with strong management teams relative to their industry.  I will let valuation stretch at those points, because there is more of a sustainable competitive advantage there.  You get more positive surprises, and that definitely aids total returns.

That said, a focus valuation is key to all investing.  The only thing more important is margin of safety.

Margin of Safety

There are three elements to margin of safety:

  1. Sustainable Competitive Advantage (Strong Gross Margins)
  2. Strong Balance Sheet (Conservative Accounting)
  3. Cheap Price vs Likely Value

This is different from other formulations of margin of safety, because one has to take into account factors that make it less certain that we can calculate value.  Many value managers were buying cheap financials up until September 2008, only to realize that their estimates  of value were wrong because credit losses would be far worse than expected.

Good stock analysis begins with good bond analysis.  If you wouldn’t buy a bond from the firm, you probably shouldn’t buy the stock.  Value investing is conservative, and looks for situations where there is little credit risk.

Conclusion

If you want to read  summary of my portfolio rules, you can find them here.  I am a firm believer in value investing, but I realize that there are many ways to approach the process.  I watch other value investors, and continue to learn.  Good value investors are lifelong learners, and generalists with broad knowledge.  It is not a narrow discipline, but one that can accommodate new knowledge.

Full disclosure: long SFG

 

1 Comment

  • Greg says:

    David, mostly I agree with you … except on reason #5 (using EBITDA).

    If we are being honest, GAAP accounting has a number of short-comings. But the issues are fairly well known. Management can … lets call it fudging numbers … management can fudge the income statement or the cashflow statement or the balance sheet — but fudging all three is nearly impossible (barring outright fraud and complicity of the auditors).

    EBITDA or the even worse “operating earnings” are a load of nonsense. Any half qualified CFO can manipulate EBITDA, and “operating earnings” are often mocked as “earnings before expenses and losses”.

    Used properly, EBITDA might have some limited uses as you describe. But in practice? It is too easy for management to make the numbers anything they want. You say “EBITDA”, and I hear massive immeasurable agency risk.

    A broker starts talking at me about operating earnings, I hear fraudulent accounting. I readily admit there are a few turnaround situations where operating earnings might be appropriate, but they are very limited in number… the over-use of operating earnings by “analysts” on CNBC is more an example of the public being scammed twice with the same con.

    I insist on looking at GAAP numbers, and I refuse to even listen to analysts who want to quote EBITDA or operating earnings.

    I can always add interest and depreciation and taxes back into GAAP numbers if and when **I THINK** it is appropriate.

    When the salesman is trying to wave his hands and distract me away from GAAP earnings numbers — I know he/she is trying to pull one over on me.

    One thing I would say about true value investors: they do their own homework and make their own decisions. They don’t let sell side con-men tell them what numbers to look at. EBITDA and operating earnings are smoke and mirrors designed to separate the stupid from their money. Value investors can add/subtract “ITDA” on their own.

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