Greenwald Lecture at Gabelli Value Investing Conference (Part 1 of 2)

okay so um welcome on behalf of dabeli Asset Management it's my pleasure to welcome you to our value investing seminar presented by Professor Bruce Greenwald of Columbia University my name is Federico Crewe Biore as many of you know and I'm a member of our London office here down in on Prince's gate value investing has been a core guiding principle for gabelli asset management since our inception in 1977 starting really with the writing and security analysis in 1934 and by Ben Graham and David Dodd value investing has remained a reliable and disciplined manner to navigate a market world that frequently ruled by speculation unjustified emotions confusion and momentum the core premise of value investing is very basic that the underlying value of a financial security is measurable and stable regardless of what the market does to it the goal of us becomes to identify and purchase securities when their market prices significantly differ from their fundamental value today's value investors have been forced to become a little bit more ingenious in their ways of identifying measuring and defining value from Warren Buffett to edwin schloss to our founder Mario gabelli the disciples of value investing are plentiful in the world today and to date no other investment decibel discipline has proved to be more successful as Professor Greenwald will go into Columbia University's School of Business has for long been the house of value investing Ben Graham and David Dodd taught there they were followed by Professor Roger Murray amongst others who was a teacher of our of our founder and today the mantle is held by professor Greenwald professor Greenwald is a Robert Halle berm professor of finance and asset management at Columbia University he is considered a leading expert on value investing the economics of information and productivity his recent book value investing from Graham to Buffett and Beyond is widely considered the third tome on the practice after security analysis in 1934 and then Ben Graham's masterpiece in 1948 the intelligent investor and I highly highly recommend that you read it as a former student of Professor Green while as I'm truly honored to be able to introduce them to you and have him here in London to present to you and I'm sure that you will enjoy being in his capable hands aside that along those lines if my memory of Professor green walls class serves me correctly the more interactive this is the more you ask questions the happier he is and you don't need to wait for a Q&A session at the end in order to bring the whole bring it all out so with that ladies and gentlemen Professor Bruce Greenwald yeah let me thank Federico for two things one is that in Italy we started this fifteen minutes late you'll be pleased to know today we're starting just ten minutes late so I'm going to steal the financial and efficiency capital of Europe at least relative to Italy second thing is that I do want you to ask questions as we go along if there are questions as Frederico said that's going to make me happy for those of you who have been in my classes that may make the people who asked the questions less happy but just remember you're doing good for the group as a whole and I will try and control myself and be civilized actually I'm here not just to talk about value investing what I'm really here to talk about is what a professional well-conceived investing process looks like just in general now obviously I'm going to be making the case that the criteria that I'm going to talk about are obviously fulfilled by value investing practices and are fulfilled by value investing practices to a degree that they're not by other approaches but there are other approaches that are characterized by investors who have been strikingly successful there are not many of them but at least if you do pursue those approaches you ought to have an idea of within the context of those alternatives what an appropriate system for investing looks like so this is really proselytize improve the overall quality of Investment Management now value investing belongs to the genre if you will of fundamental investing it involves looking at underlying securities it involves buying securities that are trading for a third or two-thirds or half or less of their actual value value investing is just a matter of buying bargains in financial markets and having bought bargains holding them for a reasonably long period of time having described it that way of course the natural question I think most of you'd want to ask is is what non value investing is that if you're buying bargains who are the people who are not buying bargains and I think it might be useful just to get a sense of that first there's a lot of short-term approaches to investing the most common approach to investing at least in terms of the research that's disseminated and the discussions that occur is what might be called short term fundamental investing what happens is that you forecast either a quarter out or a year out or two years out some appropriate quantity to do with the companies whose securities you're going to be buying most commonly of course that's earnings then you compare your forecast to the consensus either as it's apparent in surveys or as you can infer it from the stock price level of that security or the bond price level of that security and if you think if your forecast is more optimistic than the implied consensus you buy on the theory that when the news is revealed and you turn out to be right and everybody else turns out to be wrong the stock is going to go up and you're going to make money if the opposite is true if you're more pessimistic again when that becomes apparent and you're right and everybody else is wrong then the stock is going to go down but notice what's got to happen to do this successfully you've got to have information that nobody else has now the classic investor of this sort is my dentist who is a terrific investor I'm sorry a terrific dentist and a terrible investor his idea of short-term information is the demographics of the US population I guarantee you he is not the person who knows the most about that but that is an alternative style of investing and then there is a whole large school of technical investing it's a school where while you look at is trading patterns in the market momentum is the simplest of those if prices are going to go up I've been going up they're going to continue growing up some people look at fairly complicated price and volume patterns and again make short-term price projections if they're indicate prices are going to be higher they buy they indicate price are going to be lower they sell so there are plenty of alternative approaches to investment also when you look at fundamentals you're going to look at either companies or things like interest rates in the economy as a whole the other dominant school of investing for many years was basically efficient market investing the idea was that you were not going to be able to collect information better that was better than the consensus that everybody else had collected that therefore all you should worry about since you're not going to be able to outguess the market is minimizing transaction costs and allocating assets in a way that creates an appropriate risk profile what I think you ought to know about that is two things the first is and it's really why we're here there is overwhelming statistical evidence now that markets are not efficient I'll show you what it looks like tomorrow I'm going to describe some of it today but there is overwhelming evidence that in all countries in all periods of time going back now I think these studies go back as early as the early 2020s century that there are variables that pralaya bleep ridiculous that outperform the market and that clearly contradicts the premise that nobody can outperform the market so it is while it is formerly not true and it is not true in ways that obviously I'm going to talk about today you have to understand and I think this is the most essential wisdom in investing that there is a sense in which absolutely fundamentally markets are efficient and it is this that whenever you buy a stock thinking it's going to go up as night follows the day somebody else is selling that stock thinking it's going down and one of you is always wrong another way of saying that is that not everybody can outperform the market there's a famous humorist in the United States called Garrison Keillor who tells stories about a fictional town called Lake Wobegon and in Lake Wobegon all the women are beautiful all the men are tall and all the children are above average in this game all the children are average on average which means half of them are going to be below average so that when you start to think about investing you have to be able to answer the question why is your manager or you yourself going to be on the right side of a particular trade why are you the one who's right and the person who's trading with you is wrong and that's the most fundamental aspect of investing now when we talk about value investing there is a lot of evidence that value investors have been on the right side of the trade that the statistical studies that sort of run against or contrary market efficiency almost all of them show that cheap portfolios low market to book low price earnings portfolios outperform the market by significant amounts in all periods in all countries pretty much that is a statistical historical basis for believing that this is one of the approaches where people are predominantly on the right side of the trade and of course somebody else has to be on the wrong side of the trade those studies were first done in the 1930s they were done again in the early 50s they were done in the 60s the ones that we were that have really gotten a lot of attention were done in the 90s because it was only then that the academics caught on but there is statistical evidence that the value approaches the buy cheap security approaches have historically outperformed the market the problem with that is to say well they may have statistically outperformed the market but do they make money for people if you look at large institutional investors who have pursued a value approach they've outperformed the market significantly the reason that's important is that 70% of professional investors underperform the market so to see large investors from a particular discipline systematically and a large majority of them outperform the market is again evidence that that discipline has particular advantages if you look at individual investors like Warren Buffett or Mario gabelli or Michael price or any of these people and I'll tell you an embarrassing story about this in the second who have gotten very rich or disproportionately rich they are to extraordinary degree concentrated among value investors the prominent creates for me is that Mario gabelli endowed a $50,000 prize that we give away every year for contributions to value invest we would like not to give that to somebody for whom it is rounding error in their net worth we would like to give that prize away to somebody with decent who was decently poor so that it would make a difference well we thought we found somebody this year when we gave away the prize for the first year I was very pleased with myself until two weeks before we actually awarded the prize after we'd already decided and told this guy I found out he was with worth between seven and eight hundred million dollars and we have a problem for the future so in all these terms both statistical large institutional performance and perhaps most strikingly individual performance there are strong indications that value investing satisfies this criteria of putting people on the right side of the trade just to talk about it the specific assumptions that you're making as a value investor are first and this is in benjamin graham's metaphor that the market is like a partner who is manic-depressive but every day he comes to you and offers you a price for your share of the business and if he feels good that day the price is remarkably high if he's depressed that day it can be remarkably low but market prices fluctuate a lot this mr. market is a very strange guy and there's overwhelming evidence for that if they're fluctuating a lot and you think fundamental values are stable in the evidences in favor of that too then prices are going to diverge regularly from fundamental values the second assumption is more problematical it's that you can identify which stocks are trading above or below their fundamental values that means that fundamental values have to be measurable and that is by no means always the case to give you a simple example of that I sit on these panels where we advise the managers of charitable foundations invest money in the United States and invariably it's me and a bunch of people who sell money management services and they all talk about how good they are at evaluating the or estimating the value of stocks like Microsoft then this was back when Microsoft was trading at 70 times earnings when it was 110 dollars a share and comperable stocks this was in 2000 I used to sit there and think God thank God I'm not that kind of jackass that I have to be able to I have to pretend to be able to do that because the truth of the matter is that the value of Microsoft doesn't depend on what happens in the next ten years because the dividend return you're going to get over the next 10 years is at most 15 percent of the value of the stock so what you're pretending you can do is forecast what Microsoft is going to look like in those instances from 2010 on and if you do that lots of luck so it's not clear that this is always true but we're going to talk about cases where it's true and where you can do it and then another article of faith is that ultimately the fundamental values will out you hold it long enough you'll get superior returns and the market prices of these stocks will return and there's some substantial statistical evidence that that's the case when you try and put this into practice what it means is first of all because not all securities are going to be over or strikingly undervalued if you're thinking of going short you have to look intelligently for things that you're going to value then when you estimate values you have to be rigorous about knowing what you know not all value as in the Microsoft case is measurable and much more importantly as warren buffett has more or less recently proved and as you know he is the most successful investor in history but as he's recently proved with respect to silver and the value of the dollar not everybody is an expert in everything that you are not going to be good at valuing everything you're going to have to concentrate on what your own particular circle of competence is the third idea is that you look intelligently for opportunities you are rigorous about valuing those opportunities and then you have to be patient and Buffett has a little story he tells he says look investing is not like baseball or I guess cricket where you have to swing it every pitch I guess baseball it'll have to be you don't have to swing they can throw as many pictures as you want so because value implies concentration not diversification you want to wait for your pitch that's the good news the bad news as any professional investor knows is the half they run up the score whether you swing or not because you're being compared to indices so you have to have some reasonable strategy for what you're going to do when there is no obvious opportunity in these two categories now all of that it seems to me can be described as a process and this is where we get back to really much more than just value investing a sensible investor is going to start with a well-formulated search strategy some of that is going to be screening on statistical or other basis for particular opportunities to devote resources to but some of that is just going to be what you decide to do it's what you're going to specialize in because in this game the specialists are much more likely to be on the right side of the trade than the generalists if you know and live in Czechoslovakia and our well connect there you're likely to do a lot better investing in equities than somebody who flies in from New York and thinks they can judge what's going on so it is also a matter of developing that circle of competence of identifying what you're good at and I don't care if you go to value investors or not but when you go to any investor there ought to be a circle of competence there and if their circle of competence is every industry every country lots of look second once you've identified opportunities you need a sound valuation technology you want an approach to valuation that uses all the information as effectively as possible and what we're going to talk about today is what it seems to me the most effective of those technologies looks like and it's the one that was pioneered by Ben Graham that valuation technology among other things should identify the critical issues that affect the future value of your investment and you then want to concentrate on that information and any collateral indicators that will tell you like what management is doing and so on what it will tell you about that future value and finally you have to have a strategy for managing risk effectively and systematically now I'm going to talk about value investing approaches to all of this but what I hope you'll go away with at a minimum is a notion that whoever or however you invest that all these steps are being done effectively in some degree now it used to be that life was easy that from about certainly 1900 Jeremy Siegel has now gone back to till certainly 2000 which is a hundred years this is one you don't have I've got look if you're ever thinking of teaching the thing you have to remember most about teaching is that even the very best students are only listening to you about 40 percent of the time so you have to say everything three times the problem with that of course is that you're listening to yourself a hundred percent of the time and it gets pretty tired so if you don't change things a little bit it's hard to keep yourself awake this is my gesture towards keeping myself awake that if you look historically returns on stocks have been about ten to eleven percent and returns on bonds have been about three to five percent short term instruments have returned even less buying stocks was a terrific search strategy historically things no longer seemed to be that simple there are basically two ways for us and the foreign equity numbers don't look very different from this that you can calculate future returns one is you can look at dividend returns plus capital gains capital gains are presumably driven by growth in earnings growth in earnings is presumably driven in the long run by growth in world GDP it's about four point seven between four and a half and five percent you add those two numbers together buying stocks in the united states and it's very similar overseas at current valuations looks like it'll produce future returns about six and a half percent of your six to seven percent a second way to do that is to do one over the price earnings ratio and add expected inflation this number is actually these days a little higher than that this is the earnings return you get at low levels of inflation because stocks are real assets inflation gains for free this number is probably a little lower but again you get about six and a half percent it's between six or seven percent so historically while returns have been ten to eleven today probably just buying stocks you're looking at six to seven the bad news is that's about what high grade corporate bonds you so for what looks like comparable risk so just buying stocks is not by itself a successful search strategy what you've got to do it seems to me and this is what the evidence shows is you want to start looking at things that are obscure if you decide to buy Microsoft you are competing with about 200 other analysts and about thousands of investors who are looking at that company to that competition no matter how smart you are is a tough competition that's true of all the big global large cap stocks ideally to be on the right side of the trade most often you would like to be the only one seriously studying a particular security or one of a few people that's small capitalization small companies small markets particulars like spin-offs where people get us one share for every ten of a big company they own and because the market capitalization is so small they tend to dump it on the market and boring is your friend we will talk about why I think or why the psychological and institutional evidence is that that's going to continue to be the case but people like high tech people like potential lottery tickets people like exciting Securities and exciting industries and that is not where you want to be because it minimizes the chance that you're going to be on the right side of the trade so you want obscure and boring and it turns out for psychological and institutional reasons ugly in the stock market as in the marriage market although prices are inflexible in the marriage market is your friend that financial distress and bankruptcy people didn't use to touch there were huge bargains there statistically low growth low price earnings low market to book industry problems that generate that company problems or disappointing performance the reason that seems to be your friend is that those are the things that seem to get investors to dump securities reflexively that means that the person on the other side of the trade is just getting rid of those securities if you are an expert in that area as the prices fall below what's justified in many of those cases you should be in a position to take advantage of it finally every so often as when the RT C which is the Resolution Trust Corporation in the United States is dumping a huge amount of real estate on the market or in the privatizations in Eastern Europe where shares were just being dumped on the market there's going to be a big supply and demand imbalance that's likely to create an opportunity for you to be on the right side of the trader but ultimately the reason you want to search strategy is so when you've done all the analysis evaluation and this looks to you like a bargain you have to ask the question why has God been so kind or whoever it is who does this as to make this opportunity available only to you and the answer is unless you're a very clean liver which doesn't cover most of the investment managers I know there's no good reason so you have to have some sort of rationale to answer the question why are you the only one seeing this opportunity now the statistical studies that I talked about support these results and this is just sort of a summary cheap stock portfolios that is portfolios of cheap stocks and I'll show people the actual studies tomorrow outperform the market by about 3 to 5 percent if you do Oh pee and also low-growth which is you get away from the glamor stocks you get about another 1 to 2 percent on the other end hi market to book stocks underperformed by about 3% glamour stocks which are high growth and our training at high peas underperformed by the 5 percent and small capitalization stocks in obscure areas these are obscure countries companies who stock values have fallen so far that they're small or tiny little companies that the big money managers just can't spend their time with because you can only put maybe 5 to 6 million dollars at most into these stocks or 1 to 2 million outperformed by about 2 to 3 percent statistically historically these strategies that we're talking about which are the value based search strategies do seem to outperform the question that you want to ask is why do we think that's likely to continue in the future and there the answer to that question really takes two forms the first is that most trading as you know is done by institutional money managers and there are reasons why institutional money managers are for institutional reasons likely to concentrate in certain kinds of stocks which will lead those stocks to be overbought and overvalued and to therefore concentrate away from other kind of stocks that will be under bought and undervalued once that process starts by the way there is strong institutional reinforcement you get in trouble as an institutional money manager by significantly deviating from the performance of other institutional money managers you just match the performance of other money managers or nearly match the performance of other money managers you're not not going to get into trouble what's the way to do that it's to buy what everyone else is buying so once a trend whether it's the nifty 50 back in the 60s and early 70s or tech stocks in the 90s get started there is an institutional imperative that makes it go too far because money managers don't want to expose themselves to the risk of not embracing that institutional trend that trend we know in a way what it looks like because there is a phenomena that's well documented by institutions which is window-dressing that in January or before they report their portfolios regardless of their performance institutions tend to buy the stocks that have done well that have gotten good institutional research reports it's called window dressing it so whatever their performance has been when the clients look at their portfolio they say oh yes that's a good gray pinstripe portfolio I'm not upset by that and that's again a phenomena that leads to concentration in some stocks and away from concentration in others there are also institutional reasons to concentrate on stocks that have huge potential upside the respectable reason for that is that when you do your marketing it helps to be able to say well we bought Microsoft in 1990 or we bought Cisco at the IPO in 1992 or whatever are the particular events and anybody who's listened to marketing presentations by institutional money managers they talk about particular successes there's also a less respectable reason why they want to invest in that if I'm a money manager my compensation is an option if the stocks in my portfolio go way up I get paid a lot if they go way down it's very hard especially when I'm starting out for them to take money away from me again so that I have a big incentive to embrace risks of with large upsides but perhaps steady downsides because if it's a good year I do really well if it's a bad year I don't get punished and those tend to be the big glamour stocks that have the capacity the triple even if the expected return is only 5% as opposed to the stocks that on average will do better but don't have that kind of dramatic upside potential so there are institutional reasons why we think concentrating and high growth high PE glamour stocks is likely to continue there are also individual psychological reasons we're going to do the experiments tomorrow but it turns out that if you offer people the same exact choice but you couch it in terms of a potential loss people will embrace risk to avoid it if you couch it in terms of potential gain they will then do the natural thing and act as if they're risk averse so when you see events that are associated with laws bankruptcy lawsuits industry problems the evidence is that people irrationally avoid those risks they oversell those stocks also we know that people buy lottery tickets which is the individual equivalent of blockbusters all my students want to get rich in a year and a half after they leave business school they're not interested in making 22 or 23 percent a year for a long period of time and that's a regularity that's been around for a very long time lotteries are crappy investments and nobody ever lost money running a lottery even the government final point is and this is significant you would think that people would learn that the skirt of Statistics that I showed you would become embedded in how people behave because these statistical portfolios that outperformed by even 3% put you in the top 2% of money managers there are also experiments that show that people a suppress uncertainty that they believe they know what they know with certainty and that by the way leads them to tend to exaggerate both good news and bad news drive good news stocks too high drive bad news stocks too low but they never learned and this is an experiment that's worth talking about because they'll give you a feel for human nature they take psychological subjects and they show them a white square against a black background and they ask them to estimate how far away the square is so they ask them how far away is that they tell them it's between one and twenty feet away and they ask them to estimate the error bracket that is is it plus or minus a foot that your estimate is and they all give a very precise estimate like seven and a half feet and they all give very precise error brackets of plus or minus a foot what they don't tell them of course is the size of the square and they vary the sizes of the square so it turns out that physiologically you cannot tell where that square is without knowing its size so the true answer is it's ten and a half feet away on average and the error brackets are between one and twenty feet people just don't seem to grasp that reality faced with that uncertainty they impose the idea that they know where the square is then what they do is they show them the squares of different sizes and they say look these squares are of different sizes and then they run the experiment again people are not completely stupid the error brackets get wider they go from plus or minus a foot to plus or minus two feet but the people still think they know the square is so the fact in hindsight that they don't adjust means that there are these ingrained beliefs that just are very difficult to contradict in terms of the evidence so when you look at these historical regularities that as I say were first identified this outperformance of value portfolios that were first identified in the 1930s and 40s and have continued to be reaiiy denta fide it doesn't look like a big surprise when you look at the institutional and institution and individual realities that underlie investing that these portfolios have continued to outperform and until that institutional reality changes or the individual behavior changes things don't look like they're going to change so a value search strategy looks like it does extremely well that doesn't mean it's the only search strategy that's going to do well but you want to remember that 70% of investments professional investors underperform the market and the value search strategies outperform about 95 to 97% of other investors but having identified where you're going to look if you're going to employ my students you can't just do it with a computer if you're going to go to somebody who's going to do active research and active selection among these statistical opportunities you have to have a process for valuing what you're looking at that actually adds something to the statistical test and this is the most depressing thing that I'm going to talk about here most of this is good news Sanford Bernstein which is a terrific operation it's technically very sophisticated they have 200 analysts and they monitor their performance they have outperformed the market over I think it's about 25 years now by 3 percent that makes them ad then they manage by the way I think it's like 400 to 500 billion dollars now that puts them in the absolute top tier of institutional money managers if they had just done market to book based portfolios they would have outperformed the market by three point nine percent so for all that work by the most successful money manager out there they add negative one percent to their performance so the second thing you always want to look for in a money manager is an ability to value things effectively and again I'm going to talk about what in general a reasonable valuation process looks like and of course the process I'm going to talk about is the Graham and Dodd value investor process the most common way to value things that you will see all over the place our ratio valuations that an analyst will take a measure of cash flow whether it's accounting earnings or earnings before interest in taxes or earnings before interest in taxes with amortization added back or earnings before interest in taxes with depreciation amortization added back and they will apply a multiple to it it's different multiple for each cash flow but there will be a multiple and that multiple will usually be based on so-called comparable multiples that is what similar companies are trading for in the market whether it's a private market or a public market the problem is comparable is not that easy to define presumably companies with stronger economic positions should have higher multiples in a cyclical situation industry whose cash flow is cyclically depressed sure if you're interested in long-term value have a higher multiple higher leverage should lead to higher risk and a lower multiple management quality is a tough one how many people think management quality should lead to a higher multiple of course it should better managers reinvest funds more effectively how many people think management quality should lead to a lower multiple of course it should management quality is already built into the earnings they already earn a lot because they've been good managers for a long time and good managers have only one direction to go which is downhill so in that case you don't even know what the sign of the adjustment is but mostly its growth that's the problem companies grow at vastly different levels and rates and growth obviously adds under certain circumstances to multiples although as you'll see it also reduces multiples in fact when you've done all this and you've asked yourself are these cash flow levels really sustainable you're looking at errors realistically a plus or minus a hundred percent in these multiple estimates in fact of course you can also do the multiples with a computer you don't need an analyst to do them so it doesn't really add anything to valuation so this is almost an exercise in futility and thank goodness we teach our MBAs to do something more sophisticated than them now how many people in this room actually have MBAs I know there are a lot of people here from Columbia but you've got to admit it if you've got them you can't be ashamed of it ah what I hope you were all taught to do was to estimate future cash flows up to a certain year and then estimate a terminal cashflow multiply it by a factor which is usually the difference to the cost of capital and a growth rate treat that as a terminal value and discount all the cash flows back to the present that is a discounted cash flow model anybody who's men read any serious business research or any serious Wall Street research will have seen that done it has two advantages first since your use of the ratio analysis is essentially just doing a terminal value any diseases that this detailed approach has are also diseases that affect the ratio analysis it can't really be worse than the ratio analysis because you're thinking in a way more carefully about things second is it is theoretically the right thing to do on the other hand when you go through and calculate these cash flows starting from revenues margin subtracting required investment and then getting the cost of capital there are a huge number of embedded assumptions in particular anybody who's done these models should have a sense that they are very imprecise why because almost all the value is always in the terminal value for these models and the terminal value is usually a cash flow that you may estimate reasonably well times one over the difference between the cost of capital of say ten percent and a growth rate I'd say five percent which is this the growth rate of world GDP you subtract those two you get five percent one over five percent is at twenty times multiple on the other hand suppose and remember this is the growth rate from say five years out onwards not today's growth rate suppose you're off by one percent in that in either direction and one percent in the cost of capital in either direction you could easily have a cost of capital of nine and a growth rate of six 9 minus 6 is 3 percent 1 over 3% is a multiple of 32 3 you could equally well have a cost of capital of 11 a growth rate of 4 the difference of those is 7% 1 over 7% is a 14 times multiple in the critical element of value that's a difference of more than 2 to 1 and I assume most people have done this have seen that happen that is not a problem that arises from the terminal value formula that is a problem that is fundamental to a discounted cash flow approach to valuation and this is the second thing I think it's important for you to know any investment managers who are out there doing discounted cash flow measures of value are using a technique that is in practice an incredibly stupid thing to do and it'll there are three reasons for that one of which will be obvious two of which are a little less obvious the obvious reason is and it's what's reflected in the terminal value problem is that you take good information which is the near-term cash flows and you take really bad information which is your estimate of the long-term cash flows and you add it together when you add that information to good information what do you almost always get you almost always get well you always get that information because the bad information dominates what you would like to do an evaluation approach is start with the pieces of value that you know are there and segregate out the bad information that's the natural thing to do and this approach doesn't do any of that the second problem with the discounted cash flow or NPV net present value approach is that think about what you want a valuation approach to do it is a rule it's a machine for translating between the assumptions that you can make that you can make reliably about the future and the present day value of a security the inputs that you want to that machine are the assumptions that you can reliably make but think about the assumptions that you make for a discounted cash flow analysis suppose we were doing this for the Ford Motor Company or for Mercedes Benz I guess there are no more British examples that I can use sorry the DCF models are going to use or have to use estimates of the future profit rate estimates of the future cost of capital estimates of investment intensity and estimates of growth rates how many people think they know twenty years from now what Ford's profit margins are going to be ten years from now five years from now but that's what the DCF model requires how many people think they know what Ford's growth rate is going to be ten years from now five years from now lots of luck so you're using assumptions that you're not very good at making well what do you do you do sensitivity analyses you try all sorts of values but these things don't vary independently and the sensitivity analyses will usually give you any outcome you want and that's really why the investment bankers love them you're putting in smoke and of course what you get out of smoke but let me ask you other questions about Ford in the globe automobile industry 20 years from now will there be a global automobile industry you can make a judgement about that is this industry going to be economically viable let me ask another question is Ford going to have technology that no other auto company has or alternatively or other auto companies going to have technology that Ford doesn't have and again I think you can think about that finally does Ford have access to customers that other water companies don't or do they have access to customers that Ford doesn't does Ford enjoy competitive advantages and that's a question you can make a judgment about and you would like that question to be embodied in your valuation approach the third thing is you would like your valuation approach not to throw away information you would like it to use all the information available and what particularly important information is never used in a DCF analysis the balance sheet information it just disappears in favor of earnings which our income statement projections so what I would like is an approach to valuation again I'm going to describe one today which is the Ben Graham approach to valuation but you ought to know that this ought to apply it ought to organize value components from most to least reliable so you can say I know this much value $8 a share is there I'm less certain about the next 12 dollars and the next $20 is pure speculation it'll organize valuations by strategic assumptions this is the value of the industry is non-viable this is the value if Mike know companies enjoy competitive advantages but the industry is viable this is the value if there are competitive advantages that are sustainable and third you would like it to use all the information and cross correlate that information well there is a way to do that there may be other ways to do it that I'm not aware of but one way to do it is the way Benjamin Graham in 1935 and 36 thought about this problem or Benjamin Graham and later as it was refined by David Dodd at Columbia where do you always want to start a valuation you want to start with assets why because they are tangible you could technically go out and look at everything that is on a firm's balance sheet even the intangibles like the product portfolio you could investigate it today without making any projections or extrapolations you could even investigate the quality of things like the trained labor force and the quality of things like their business relationships with their customers start with that that's your most reliable information it is also all that's going to be there if this is not a viable industry because if this is not a viable industry this company is going to get liquidated and what you're going to see is the value in liquidation and that is very closely tied to the assets in that case with that strategic assumption you're going to go down that balance sheet and see what's recoverable but suppose the industry is viable suppose it's not going to die how do you value the assets then well if the industry is viable sooner or later the assets are going to be replaced so you have to look at the cost of reproducing those assets as efficiently as possible so what you're going to do is you're going to look at the reproduction value of the assets in the case where it is a viable industry and that's where you're going to start and we'll talk in a second just a little bit and more tomorrow about the mechanics of doing that reproduction asset valuation but that's value that you know is there the second thing you're going to look at because it's the second most reliable information you have is the current earnings just the earnings that you see today or that are reasonably for castable as the average sustainable earnings represented by the company as it stands there today and then we're going to extrapolate we're going to say suppose there was no growth and no change what would the value of those earnings be let's not get into the unreliable elements of growth let's look secondly at the earnings that are there and seeing what their value is and that's the second number you're going to calculate but it turns out those two numbers are going to tell you a lot about the strategic reality and the likely market value of this company this is a chart you should oh no this is also a chart you don't have but the gabelli people will get it to you you just have to pay attention it's a concept chart anyway suppose this a commodity business it's a division or it's something like allied chemical and you've looked at the cost of reproducing the assets and you think you've done a pretty good job of that and you could build or add plants accounts receivable cash and inventory that represents this business customer relationships a product line for a billion dollars and that's usually going to be the cost to their most efficient competitors who are the other chemical companies so the cost of reproducing this company is a billion suppose that on the other hand its earnings power is 200 million and it's cost of capital is 10 percent say that the value of its earnings which mimics its market value is 2 billion a year what's going to happen in that case is that 2 billion going to be sustainable well think about what's going on in the executive suites of all these chemical companies they're going to see projects where they can invest a billion dollars and create 2 billion dollars of value what are these guys love better than their family's chemical plants so you know those chemical plants are going to get built if there's not something to prevent it and to prevent that process of entry as the chemical plants get built what's going to happen to the price of this chemical it's going to go down the price of the chemical goes down profit margins are going to go down the earnings power value and the market value is going to go down suppose it goes down with billion-and-a-half is that going to stop the process of entry no not at all because the opportunity is going to still be there in theory the process of entry should stop when the market value just is equal to the cost of reproducing those assets in practice of course I'll do this because some of you how many of you have kids there's a life lesson here how many of those kids want pets practically all of them well there's one thing you have to know about giving kids pets to have a lot more enjoyable to buy a puppy than to drown it later that once those puppies are bought you are stuck with them and the same thing applies to chemical plants once those chemical plants are in place you are stuck with them and they're likely to stay there for a long time so typically the process may not stop there at all yeah it applies equally to differentiated products suppose Ford to reproduce their assets of the Lincoln division is 25 billion and the earnings power value and market value is say as much as 80 billion what's going to happen then Mercedes and the Europeans and the Japanese are going to look at that opportunity and they're going to enter now do prices necessarily fall no not in this case they match for its price but what's going to happen to Ford's volume sales inevitably they're going to go down because they're going to lose sales to the entrance what therefore is going to happen to their unit fixed cost it's going to go up their variable costs aren't going down so their unit costs are going up the prices are standing the same their margins are going down and they are super unit sold and their sales are going down so what happens to profits here only in a different way with a differentiated product exactly the same thing the differentiated products won't save you and that will go on until the profit opportunity has disappeared unless there's something to interfere with this process of entry this market and earnings power value is sooner or later going to be driven to the reproduction value of the assets especially in the case of the internet you had companies that were worth more they didn't have any earnings ten five fifteen billion dollars whose assets could we be produced for a hundred million ten million 15 minute unless there's something to stop the process of entry the earnings to support that are not going to materi laws so what you're looking at is if you have earnings power in excess of the reproduction value of the assets this is going backwards a page there had better be something to interfere with the process of entry that's something which goes by the term of barriers to entry is actually the same as an incumbent competitive advantage so any excess of earnings power that's sustainable over the reproduction value of the asset has in fact to be attributable to access to compare it is excess earnings and it's got to be protected rather by barriers to entry which are incumbent competitive advantages the nature of which we'll talk about tomorrow and then and only then should you worry about the growth but you'll notice that in those first two cases we've looked at value from us most reliable to next most reliable to least reliable perspective and also in terms of our assumption about the nature of the industry which is that there's no competitive advantage it's the asset value which should be mirrored by the earnings power value if there are competitive advantages it'll show up in excess earnings and you better be sure that they're sustainable because that's where the value is coming from is those competitive advantages now I want to quickly talk about mechanically what's involved I'm going to talk about this at much greater length tomorrow during an asset value is just a matter of working down the balance sheet go through the balance sheet ask yourself what does it cost to reproduce the various assets this is a hint of what that is and then for the intangibles list of like the product portfolio and ask what would be the cost of reproducing that product portfolio for the earnings power value you have to calculate basically two things you have to calculate earnings power which is the current earnings adjusted in a variety of ways that I'll talk about tomorrow and you've got to multiply it just by one over the cost of capital there is an assumption based on an earnings power though and part of it is being careful about what earnings are this is just a picture of what some of those adjustments look like you've got to adjust for any accounting shenanigans that are going on you've got to adjust for the cyclical situation for tax particular tax situations that may be short life for excess depreciation over the cost of maintenance capital expense and really for anything else that's going on that is causing current earnings to deviate from long-run sustainable earnings so it's long-run sustainable earnings multiplied by 1 over an appropriate cost of capital what you've got them are two pictures of value you've got an asset value and you've got an earnings power though and now you're ready to do serious analysis of value if the picture looks like K say what's going on assuming you've done the right valuation here if it's an industry in decline we haven't done a reproduction value when you should be doing a liquidation value what it means is that you'll have say 4 billion in assets here that's producing an equivalent earnings value of 2 billion dollars what's going on there if that's the situation you see it's got to be bad management that the management is using those assets in a way that is not producing a comparable amount of distributable earnings in this case the critical issue is almost always it'd be nice if you could buy the company below both asset earning power value but typically you pay to reduce the earnings power value and all this asset value is sitting there in that case you're going to spend your time reading the proxies and concentrating on the stability or hopefully lack of stability of management that in that situation the issue is pre-eminently a management issue and the nice thing about the valuation approach is it tells you the current costs that that management is imposing in terms of lost value that is not something that is revealed by a DCF analysis and there are a whole class of value investments like that and one of the great contributions to the theory of this business is Mario gabelli z' idea that really what you want to look for in this case is a catalyst that will surface the true asset value and you can wait sometimes that catalyst may be Michael price or Mario gabelli if they own enough for the company I would like to encourage you if your big investors to make that catalyst you the second situation is this one where the asset value the reproduction of the value of the assets on the earnings prior value are essentially the same that tells a story just like any balance sheet and income statement tells the story it tells the story of an industry that is in balance it's exactly what you'd expect to see if there were no barriers to entry and if you look at this picture and then you analyze the nature of the industry and you say for example well this is the rag trade I know in the rag trade there are no competitive advantages you now have two good observations on the value of that company if it were ever to sell for a market price down here you know that's what you're getting that you're getting a bargain from two perspectives from both the perspective the assets and the current buy we have ignored the growth but I'm going to talk about the growth in a second the last case is the one that we really first talked about where you've got earnings power in excess of asset value the critical issue there especially if you're going to buy the earnings power value is is that earnings power value sustainable and that requires an effective analysis of competitive advantages in the industry and what I'm going to talk about for the second half of tomorrow is how to calculate or how to think about that analysis all right what I'm left with them is the growth and that's what I'm going to talk about next so I've looked at the earnings power I've looked at the asset value I've looked at the critical issues to which they give rise now I'm going to look at the growth and actually at this stage of the game looking at the growth is surprisingly easy the standard view of short-term analysts is that growth is always valuable that is wrong growth is relatively rarely valuable in the long run and you can see why with some simple arithmetic let's just look at growth and we're I'm not going to look at from the growth rate of sales I'm going to look at it from the perspective of the investment required to support the growth now the investment required to support the growth is zero then of course it's profitable but that happens almost never to you've got accounts receivable and other elements of working capital to support growth suppose the investment required is a hundred million and I have to pay ten percent to the investors who supplied that hundred million dollars the cost of the growth is ten percent of a hundred million which is ten million suppose I invest that hundred million in growth at a competitive disadvantage I'm Walmart and I decide to invest that money competing with a well entrenched competitor in southern Germany am I going to earn ten percent on that investment almost never if that case I'll be lucky to earn anything I may earn six million but the net contribution of the growth is the ten million cost to the funds minus the six million benefit which is minus four million dollars for every hundred million I invest growth at a competitive disadvantage has negative value suppose it's a industry like the automobile industry or most industries with no barriers to entry it's a level playing field well sooner or later the return on that hundred million is going to be driven to the ten percent cost by the entry of other competitors so I'm going to pay ten million I'm going to earn ten million the growth has zero value the only case where growth has value is where the growth occurs behind the protection of an identifiable competitive advantage so growth only has value where there are sustainable competitive advantages and in that case usually what barriers to entry means is that there are barriers to companies stealing market share from each other there's usually stable market they're asymptomatic of that last situation that means that in the long run the company is going to grow at the industry rate and in the long run almost all industries grow at the rate of global GDP so in these three situations the growth only matters down there in the last one and the critical issue in valuation is either management and the value in the gram and dot approach will tell you the extent to which that's important or you have a good reliable valuation and there's no value to the growth because there are no barriers to entry or it's down here and there obviously if you can get the growth for free you could pay a full earnings power value and get a decent return now just to summarize about growth growth at a competitive disadvantage destroys value growth on a level playing field neither creates nor the story's value and it's only growth behind the protection of barriers Aintree that creates value in terms of process then what you start with is a search strategy that's designed to answer the question why is this opportunity available only to me is designed to focus your resources effectively you want evaluation technology that works well that uses all the information that uses in particular the judgments that you can make about the nature of the industry and that organizes value components by reliability class and I've suggested one that does that which is obviously the gram and dot approach conceivably there are others out there you would also like them this valuation technology to identify key issues you would like any potential decision once it's been thrown up by your search strategy or identified by your search strategy it's been valued in terms of valuation it looks like a bargain you wanted an review the appropriateness of that decision all right because remember you have to be sure that you're on the right side of this trade the first part of reviewing an evaluation assessment is to understand what the key issues are that underlie that purchase decision if you're buying earnings power especially if implicitly you want the growth the crucial issue is the strength of the franchise it is not the growth rate anybody who has a strategy of buying companies whose growth rates are above their pease is an idiot' growth only has value if it's a strong franchise and it's significant that the successful buyers of growth the successful growth investors like warren buffett and to a lesser extent one of my ex students call William Vaughn month he's got a shorter but outstanding record focus on the strength of the franchise as reflected among other things by returns on capital you're going to buy growth that is going to be the critical issue its strength and its sustainability and therefore the issue of competitive advantage if you're buying assets the crucial issue is going to be management you're going to want to look for gabelli type catalysts to make sure you're just not going to get your money trapped with the old management and they're not going to earn a decent return for you you want to then look at collateral evidence are the insiders buying or selling it's not determinative but it's something you want to look at you think it's a great opportunity and the insiders are selling with both hands my advice is to look at it again who are the insiders they're usually management you want to see who the other investors are obviously it's critical in the management case you've got five activists investors who own 44% of the stock who are good activists value investors that's a good sign if it's a green male or who's going to go away that doesn't do who's going to be bought off that doesn't you any good at all usually if it's in his area of expertise and Buffett is buying it that's a reassuring sign so you want to look at who else is buying and selling this particularly the investors in insiders and that information is available the last thing you've got to look at is remember those psychological biases that we talked about are deeply ingrained and the bad news is they apply to you as much as to anybody so you have to track rigorously or your investors have to track rigorously their own performance you can make a mistake once that's fine but if you make it again that's not a good idea so you have to have a good search strategy a good valuation technology a full review of the crucial issues and you have to have a good strategy for managing risks in value investing the fundamental way you manage risks is to know what you're buying now that means that there are certain risks that you ought not to be exposed to and certain risks that you're prepared not to worry about and I think the best example of this that I can think of does everybody here know what a REIT is an REI T it's basically a security that's backed by real estate investments if you look at a building the building generates income if you buy the building based on the income its generating you are not to worry much about fluctuations in the value of the building if you're a long-term investor on the other hand if there are fluctuations in the real estate market and the value of that building you do want to worry about those too because you may have to generate liquidity so that you want to worry about earnings powers of the companies that you're buying you want to worry about assets let's suppose the real estate returns are the same the values of the buildings are the same but the price of the wheat is fluctuating all over the place do you care about that last risk you want not to that last risk is purely financial it's purely the market being irrational and if you know what you're buying but you get caught by one of those fluctuations you ought not to care that much if the franchise is there it's earning what it was earning the asset values continue to be there fluctuations in stock price ought not to be your primary concern it's understanding the value in the earnings power of the buildings that you care about on the other hand to protect you against those fluctuations and Wern above normal turns you want a margin of safety you don't want to buy something 10 5 or 15% below your estimate of its fundamental value you want to buy it for 30 percent or a 50% or more discount those are basic ways to manage risks that you think people would worry about what price am i paying and what am i buying and how sure am I about the characteristics of that and those are essentially the key ways in which value investors manage risk beyond that diversification helps but if you're fully diversified of course you're just going to be behind the market if you're fully diversified you're not going to be an expert in any particular securities so some diversification certainly but inevitably if you're looking for above average returns you're going to be concentrated and you're going to come back to these things for asset buys catalysts are things you want to look for if it's a bargain if it's the asset value is $100 a share it's trading at $25 a share and has been trading at $25 a share for years you don't want to buy it at 25 or $30 a share until you see events like a takeover a deathly disease in the family of the owner activist investors getting involved that are likely to surface that strategy and finally you want investors to be patient the end of the biggest generator of risk is people who are board buying things that seem like a good idea at the time where people under pressure doing things that they feel they have to do so you want somebody with a good default strategy what's a default strategy it's what you're going to do when you don't have any good active ideas if you're dealing with family money that's very risk-averse the obvious default strategy is care if you're an equity manager the obvious default strategy is just to buy the index but it's clearly something like an efficient markets portfolio allocation because this is the world where you don't have good active ideas but if you have a good default strategy in place you're going to be patient enough not to do stupid things in general therefore what you're looking for in investment management is a good search strategy a good valuation technology a good review process and a sensible risk management strategy value investors it seems to me both historically and in theory have done extraordinarily well in all those areas but if you find other investors who meet all those criteria by all means embrace of thank you we go just on time

Channel: Akinyemi Ogunsanya

Views: 37,146

Rating: 4.8080001 out of 5

Keywords: Lecture (Type Of Public Presentation), London, Gabelli, Gabelli Asset Management, Mario Gabelli (Billionaire), Bruce Greenwald, Greenwald, Value Investing (Literature Subject), Finance, Investing Philosophy, Columbia University (College/University), Gabelli Value Investing Conference, Princess Gate, Behavioural Finance, Conference, Greenwald 2005, Benjamin Graham (Author)

Id: OT-U0oUFnEc

Length: 84min 18sec (5058 seconds)

Published: Mon Jun 16 2014