Outperform The Market With This Step-by-Step Strategy

i think bruce bruce greenwald's class at columbia is very good he gets in a lot of people that are practitioners so there's a lot of practicality to the course and i think bruce is good he's got a new book coming out that that probably within the next six months or so that we'll deal with that hi bruce ben graham started the path to value investing back in the 1920s in columbia followed through with the epic book in the early 1930s but uh you never dreamt that you would come along many years later and teach thousands of young men and women how to be a terrific value analyst uh i have run into literally dozens of people who attribute their success in investing uh to the class they uh took with you in fact as you know one of the two investment managers i've chosen at berkshire got a huge impetus to their education i took your class todd combs and i just i just have met dozens and dozens and dozens of people who who said it was the best class they ever took and i know i had a chance to participate in a few times and it was wonderful to look out at the faces of of young people who were getting a chance to learn more about investing than virtually taking place at any other educational institution in the world so congratulations all you've done and i wish you the very best in your retirement all right thanks for the very gracious introduction i'm going to be a little less gracious to start because one of the first things that you learn and probably the most important thing that you learn about teaching is that even your best students are only listening to you about a third of the time unfortunately you listen to yourself all the time so it's very hard to force yourself to repeat everything three times the best way to do it is in response to questions so when i set the rules here i'd like to make it clear that you are welcome to interrupt with questions at any point to encourage that i would like it if the people in the in the last 60 rows would move up front to the first hand so that i could actually see you i realize that's slightly ungracious but you will help me a lot if you do that and as i say you should feel free to ask questions at any point what i am going to talk about tonight is actually peculiarly for this economics department how to get rich what we're going to talk about is an approach to investing that goes by the name of value investing it's associated with benjamin graham it is in at least three senses demonstrably or at least empirically the most successful way to invest and we'll talk about why that is what do i mean by that there are simple statistical realizations of this approach that is building statistical portfolios with no detailed knowledge of companies in the spirit of the investing that i'm going to talk about that consistently outperform market portfolios by a wide margin which means among other things that efficient markets theory in the traditional academic sense is grossly contradicted by the existence of these portfolios that can outperform the second thing is that when you look among the institutions and you look at their performance in investment these are the investment management firms the quote value firms are on average significantly more successful than the other investment firms and the third thing is that if you look at individual investors who've done extraordinarily well starting with warren buffett but by no means limited to him the representatives of this school of investing are grossly disproportionately represented in that group of highly successful investors having said that however they do a terrible job of explaining what they do this is typically their description what you do is you look at a stock or an enterprise where you think you can calculate the value and you try and buy it for a third that is a 33 to 50 percent discount from what it's worth the basic idea here is you hunt for bargains the reason that that's not i think particularly persuasive is that as far as i know there are no investors out there either professional or otherwise that are energetically and persistently trying to buy dollar bills for two dollars to pay more than things are worth everybody thinks that they're getting bargains when they buy securities so you've obviously got to think in much more specific terms about what's involved in some sense you can do that by simply looking at a taxonomy of the ways in which people look at investing if you start on the right hand side here there is modern portfolio theory and modern portfolio theory takes the view that nobody is going to consistently outguess market prices if you're not going to succeed at it you might as well try not try to do it you just buy the market portfolio and you manage risk by simply trading off between a market portfolio and a risk-free asset what investing is all about therefore is that managing risk component and minimizing transactions costs that is an alternative there are in addition people who take a short-term view of calculating value they either try and forecast next quarters or next year's earnings which is a one-year forecast forecast value on the basis of that particular picture and look for bargains in those terms or they try and just track price trends prices are going up they're going to keep going up so future prices are going to be higher than current prices and they try and get bargains that way everybody is trying to get bargains in various ways to some extent what this school involves is looking at companies as a whole and trying to figure out not what the value change is going to be or what the market price change is going to be but what they're worth in some absolute sense but again there are lots of other ways of doing that so at least we know that there are many approaches and many non-gram benjamin graham that was talked about approaches to investing to think about what are the best ones what i'd like to do is ask you a question and i'm assuming everybody here has had some money run through their hands and has put it to work in some degree so if i were to ask you what you think the most important thing to remember when you invest is what would you say anybody you can look at the underlying cash flow that is important but it's not the most important thing and when i tell you what the most important thing is it'll be absolutely clear that it is a capital gain well the idea is you're right you should always make money and never lose money as a principal for driving an investment strategy it's not clear how you're going to implement that anybody else risk you've got to pay attention to risk it's important it's not the most important fact the most important fact is this while markets are not efficient in the academic sense there is an absolutely inescapable sense in which markets are efficient and it is this do you all know who garrison keeler is okay only in lake wobegon can all the portfolio managers outperform the market it is mathematically unavoidable that the average return or it's mathematically certain that the average return to all investors has to be the average return on all assets because everybody owns everything and the derivatives net out there's a buyer and a seller of every derivative that means if you're going to be above average somebody else has to be below average i think the right way to think of that is and even though what i just told you is rigorous what i'm going to tell you now is not quite rigorous but it captures the spirit of that you can never forget that every time you buy a security thinking that's a good idea because it's going to produce a decent risk-adjusted return somebody else is always selling you that security thinking exactly the opposite so when you develop a investment strategy and this really is where ben graham started in this you have to ask yourself why do i think i'm the person on the right side of this transaction and that's what's going to drive everything that i'm going to talk about tonight and it's what ought to drive your selection of investment managers your selection of investments and so on why do you think you're the person who's going to do well here to think about turning that into an operational approach you've got to think about uh oh i'm going to well i can do this you want to think about what an investment process in its most general sense looks like first thing you have to do is you there are literally hundreds of thousands of securities and millions of securities and investment ideas out there you're not going to look at them all so you have to have a search strategy some of those strategies actually are define what a firm is so there are fixed income investors who are searching only among bonds which are fixed income investments and there are equity investors who buy stocks so sometimes that search strategy is embedded in what the firm does once that search strategy has generated or identified a security or an investment opportunity worth examining in detail you have to have a technology for valuing that opportunity the search strategy should throw up opportunities where you are likely to be on the right side of the trade the valuations approach that you take should be better than the valuation approach of the person on the right side of the on the other side of the trade and just to give you a preview for what's going to happen here thank god what everybody in this school and everybody at columbia and everybody at harvard is teaching people to do in terms of valuation is a really stupid thing to do in practice and we're going to talk about that the third step is you're going to do active research you're going to look at collateral indicators you're going to track your own past behavior you're going to do focused investigations to collect information and you want to do that and all those things in an efficient and comprehensive way so they're not going to put you at a disadvantage and if we have time we'll talk about ultimately how you're then going to go about managing risk those are the four steps in any active investment strategy or even passive it's just you don't do much particular research if you're doing a passive say buying a market index strategy so we're going to talk about them one at a time what is the kind of search strategy and the simplest one is one that almost nobody in the world does to put you on the right side of the trade that's essentially right but it's in a sense more focused than that you want to be a specialist if i've been doing onshore south texas gulf coast oil leases for 20 years and that's all i do and you fly down from new york and buy a lease from me at my price who do you think is on the right side of that transaction specialization that is focusing your intelligence has enormous power and almost nobody does it in the investment field if you look at even warren buffett he has he is essentially a specialist in four industries banking he owned a bank and he's consistently invested successfully in banks obviously insurance where he owns companies and has invested very successfully consumer non-durables where the same applies and media where young's newspapers and tv stations and has successfully traded them if you look at his returns outside those areas they are still good but they're nowhere near as good as his returns in those areas so the first thing you want to think of and it is extraordinary how rare this is you want to think of looking for investment managers or yourself being specialized it turns out however that beyond specialization there are strategies that just in general will identify opportunities that on average outperform the basic market and you can do it statistically uh oh that's close enough what happens in times of crisis when everybody okay we're going to talk about that in just a second that is a simple example of a more general principle the stocks you want to look at if you're not going to be a specialist are stocks that are obscure so ideally you're the only one looking at them small companies in far away places but most important look really bad they are undesirable where you as an investor look at that opportunity whether it's because this is a time where everybody thinks things are falling apart or this is an industry that's in real trouble or this is a company that's in real trouble and you look at that and you say oh i'm not investing in that and when you see that that's actually where the opportunities are it is obscure ugly sometimes other supply and demand imbalances but cheap stocks that you want to do portfolios simply that consist of the 10 of cheapest stocks on any stock exchange in any extended period in the united states and in almost every country but italy and it's reassuring that it doesn't work in italy outperform the overall market depending on how often you trade those portfolios and so on by between three and six percent and you can do it just by statistically applying that test calculating a ratio of market value for the company to its book value and picking the lowest market to book ratios and that will do phenomenally not every year but over time that will do finale now it's interesting what those portfolios look like two-thirds of those stocks go bankrupt but the ones that don't do so well that those portfolios significantly outperform the market at the high end if you buy expensive stocks that are attractive that have compelling growth opportunities they underperform the market by significant amounts a little less not quite the three to six percent maybe two to four percent if you do a long short portfolio it's the best portfolio makes about one percent a month with no net market exposure and that's just applying these principles in practice and the question is why is it that we think that this has worked and has worked for as many years as it has and the answer increasingly has come to be that it is taking advantage of systematic human misbehavior that most investors just cannot help themselves but reproduce so and i think there are probably three elements you want to concentrate on here there's a whole field of behavioral finance that documents these but there are probably three that really matter the first is that in every society we know of lotteries have been successful enterprises people buy lottery tickets they have always been mathematically really crappy investments worse when the government does it than when the mafia does it but in any case you lose between 30 and 70 percent of your money yet persistently people buy lottery tickets why because people will over pay for the dream and the opportunity to get rich quickly in markets that means they will overpay for the glamour stocks where they think that's a possibility so on the one hand you have that which leads to overvaluation of the glamour stocks if you simply avoided them you'd actually improve your return above the market average second thing is that people and the technical name for this is loss aversion people don't like looking at ugly opportunities with high probabilities of loss they just don't like looking at it and if they don't look at it carefully they're not going to buy it that means that the ugly stocks are going to be oversold they're going to be sold so the person on the other side of that trade is just dumping it and you can get a really good price and that of course complements with an e the lottery ticket effect now what actually amplifies these two things in terms of individual behavior is human beings are constituted and cannot stop themselves from believing they know what they know with a vastly higher degree of certainty than is warranted in the debate on weapons of mass destruction in iraq nobody said there are weapons of mass destruction in iraq with probability 60 or probability 40 but that was the reality in advance nobody knew they all decided either that there were for certain or there weren't when they apply that to stocks they decide the good stocks are good stocks for certain and the bad stocks are bad stocks for certain and nothing is certain now this kind of behavior is so compelling that i'll just tell you one of the experiments that you'll see people cannot help themselves so one of the seminal experiments in this area of overconfidence is people were asked to look through eye holes into a dark room at luminous squares and they were told the squares were between one foot and 20 feet away from them and they were simply asked to estimate how far away the squares were and to put arrow brackets on their estimates what the psychologists didn't tell them is they had a complete set of squares from that big to that big that they chose at random and the answers that people gave were completely uncorrelated as they should be with where the squares actually were the right answer should be ten and a half feet plus or minus nine and a half feet everybody gave a very precise answer they said oh that's 14 feet away that's six feet away that's five feet away and the air brackets they gave were plus or minus a foot so in a situation of radical uncertainty people impose certainty on that situation and you can see how that's going to amplify the overvaluation of the glamour stocks and amplify the undervaluation of the ugly stocks the other thing you want to know is people don't learn these experimenters decided that maybe they didn't understand that there were squares of different sizes so they actually showed them the squares of different sizes and they re-ran the experiment and people still gave very precise answers about where the square was they were still completely uncorrelated with where the square was and the error brackets went up from plus or minus a foot to plus or minus two feet people learn a little but they don't learn much and those individual behaviors are things you can take advantage of systematically and you do when you buy the ugly undervalued stocks and portfolios of those stocks and stay away from the overvalued glamour stocks now you would think that institutions might act to control these individual irrational behaviors all the evidence is that they amplify them if you're a portfolio manager and you underperform the market it turns out your clients will stick with you if you don't underperform by that much so if everybody else is buying the glamour stocks what's the low risk thing for institutions to do buy the glamour stocks yourself when you're marketing what these companies talk about is their big successes their lottery tickets and you can't get those if you don't buy the lottery ticket stocks they never talk about the near bankrupt stock that came back from death so for marketing purposes they tend to put together portfolios that appeal to those index to those instincts and they concentrate on trying to get blockbusters that they can talk about so all the evidence we have is that institutional behavior amplifies this individual behavior so in terms of a search strategy it's either specialization or cheap ugly and unappealing and obscure or both and ask yourself how many investors actually do that and the answer is vanishingly small that is however only the first step in a successful active investment strategy that basically identifies stocks so if you subsequently after careful calculation and research and consideration identify those stocks as bargains you know at least why god or whoever determines these things in the stock market has made that opportunity apparent only to you it is a rationale for why you if you find this as a bargain it probably is a bargain and the search strategy will get you 80 to 90 percent there those these statistical portfolios have outperformed by basically four percent for outperform the market by four percent for the last almost 50 years but you also if you don't want to just do a simple statistical portfolio you actually want to add value you have to then know among these opportunities that you've identified which are the real bargains and which are only apparent bargains that are probably not worth what they seem to be worth and that is what valuation is all about so once you've identified you've had you've done your search it's produced an opportunity and now you've got to value that opportunity and there is a gram-and-god or value investing approach to valuing opportunities to think about it though what you have to start with is an idea of how people in practice value things when randall gets to wall street what he will see is that mostly the way people value things as they do an estimate of some continuing cash flow either earnings net income or earnings before interest and taxes or earnings before interest in taxes with accounting amortization added back or that with depreciation and amortization added back and they slap a multiple on it and the multiple comes from god knows where but presumably it's what comparably attractive stocks per unit of cash flow are trading for well what is comparably attractive means it means that it has to have the same economic strength and position it's the same place in the business cycle it's got the same level of leverage and risk and therefore cost of capital it's got the same rough management quality and it's got the same growth prospects lots of luck finding things that have that degree of accuracy so people just very carelessly slap multiples on things and they say okay this is worth 10 times ebit or this is worth 12 times earnings before interest and taxes plus depreciation and amortization or sorry seven times that if you're doing that you should be clear you're doing what everybody else is doing and there's no advantage there so what do we teach our students to do and this is something i hope every at least mba here is familiar with what we teach them to do is a discounted cash flow they estimate revenue year by year they estimate margins year by year making assumptions about consumer competitor behavior technology and costs and management performance they subtract from those net earnings required reinvestment which again depends on estimates of technology and what they have to invest to sustain their position they get a they subtract taxes from that they get an after-tax cash flow they estimate a cost of capital and they discount each year's cash flow by one over an appropriate discount factor that's one over one plus that cost of capital raised to however many years in the future it is everybody broadly familiar with that process okay has have people actually done it is there anybody here who spent their life doing discounted cash flows i mean every mba student in the world has done that what do you always find when you do it all the value is in the terminal value and the terminal value which stands in for future cash flows beyond seven years is an estimate of that seventh year cash flow times one over the difference between a cost of capital and a growth rate a typical cost of capital is 10 a typical growth rate is five it's one over five percent which is 20 times that terminal cash flow but suppose seven years from now it was not a five percent growth rate it was a six percent growth rate it was not a ten percent cost of capital it was only a nine percent cost of capital that's one over three percent which is 33 times if it was 11 and four it's one over seven percent which is 14 times this estimate is a joke now there are good things to be said for this approach if you knew what these cash flows were and you knew the appropriate discount factor it will give you the right answer to what these things are worth it's theoretically the right thing to do also you want to understand it encompasses the ratio evaluations it's just that you're doing the ratio as a terminal value after estimating a stream of cash flows rather than just estimating it up front on the other hand in practice this is an incredibly stupid thing to do especially in terms of what's happening on the other side of the trade the first problem with doing this is that it ignores a crucial piece of information and it was what my astute introducer talked about there is no place in these discounted cash flow models or net present value models where you look carefully at the balance sheet the balance sheet is in a sense the most reliable information that you have because it's what's actually there that the accountants can look at today if you're not looking at the balance sheet and i'm looking at it carefully not all the time but it should be clear that a significant amount of the time that balance sheet information is going to be decisive and i'm going to be on the right side of the trade and you're going to be on the wrong side of the trade so any investment technique that ignores a crucial piece of information is not a good way to value anything the second problem here is actually as you're more serious than the first one but it's not more complicated and it's really why that terminal value which is so badly estimated destroys the value of this approach if you think of these net present value calculations what they do is they estimate future cash flows they apply weights to them which are lower the further in the future they are and they add them all together where the terminal value stands for the far distant cash flows well what are you doing there you're taking very good information which is the near-term cash flows and very bad information which is the distant cash flows and you add it together and when you add bad information to good information what do you wind up with the bad information dominates there is no attempt in this framework to segregate what you know reliably from what you know semi reliably from where the prayer in a dream is in estimating the value of this investment the third problem with the npv approach is a little more subtle but not much what are the assumptions that you make in estimating that net present value well let's say let's talk about the ford motor company i have to know the profit margins for the ford motor company i have to know the sales for the ford motor company for the next seven years and therefore the sales growth rate i have to know the level of investment in the capital intensity and these are all parameters i have to know i have to know the cost of capital over this period another price how many people think they know that for the ford motor company over the next 30 years lots of luck with that on the other hand are there things that i know with reasonable confidence about the ford motor company into the future and let me start is there going to be a viable global automobile industry yes the reason i say that with such confidence is that in 1967 i was the budget examiner as a summer student for the newly created urban mass transportation administration we were going to move beyond highways and they hired mackenzie for what was then an enormous amount of money to forecast the future of modern developed country transportation and mckenzie came back after spending the three million dollars and said future transportation is going to consist of multi-use right-of-ways occupied by individually targeted vehicles cars trucks and buses on roads and they were right here we are 30 years later and that's what it looks like that's not going away is there going to be a viable north american automobile industry 30 years from now that's a little harder but the answer is yes and the reason is that what's the disadvantage of making cars in north america it's labor costs what's the advantage it's savings on transportation costs and being close to the customers what's happening to labor costs as productivity grows rapidly in the automobile industry they're going down so the disadvantages are shrinking and the advantages are not shrinking at nearly the same rate so there is going to be a viable north american automobile industry third question is is ford likely 20 30 years from now to have technology access to customers or scale of operation that in any way differentiates them from the other big global automobile companies are they in a word going to enjoy competitive advantages that are sustainable since no auto company has for a long time in the past it's not going to happen in the future it's a competitive market and it's unlikely that somebody's going to dominate those three strategic judgments about the industry are assumptions that i would like to use in my valuation meat grinder rather than these assumptions about parameters of which i have no idea and a dcf is not a context in which it's easy to use those strategic assumptions so what you would like as a valuation methodology is an approached evaluation where you use all the information you organize it by reliability components and you organize it by underlying strategic assumptions so i can say this is value i have confidence in this is a piece of value i have less confidence in and this is how those values depend not on parametric assumptions but strategic assumptions and the real tribute to benjamin graham is that in the 1920s and 30s he developed an approach for doing this that is surprisingly simple and this is it you're going to start with the assets why because it's the most reliable information you have about a company you can go out and look at the plants that are on the balance sheet at the product portfolio that they may have bought at their accounts receivable in inventory it's all there you don't have to do projections so start there when you go to value a company because that's the best information and that's where you want to start let's make a strategic assumption if this company is not economically viable how are you going to value that balance sheet at liquidation value because if it's not viable it's going to get liquidated and that's the value you're going to realize could be an orderly liquidation where you get some interim profit but that's the way you're going to think about it if it's an economically viable industry like ford how are you going to value that company and the answer is at the cost of reproducing those assets in the most efficient possible way why because if it's a viable industry people have to be willing to invest in it for them to be willing to invest in it they have to get returns that are at least equal to the cost of that investment so you want to know what is the cost of reproducing the assets that have to be there for this to be a viable industry so you look at reproduction values of assets you just go down the balance sheet start with cash which is easy accounts receivable it's going to be a little higher than the balance sheet number because how do you reproduce accounts receivable you got to sell to people and there are some write-offs inventory it's going to be same well it's not going to be first it's not going to be it's going to be first in first out not last in first out because that's how you have to in reality generate for plants it's going to be the cost of reproducing them now there the advantage is that industry knowledge that you're actively collecting can be put to work in a straightforward way that the other side of the trade is not doing it i'll give you an example suppose this is an oil refinery that's the big asset of this company and it's got a capacity of say a hundred billion barrels a hundred thousand barrels a year and the cost of building new refineries capacity is about twenty thousand dollars per barrel which would put a 200 million dollar value on that refinery is that the way you want to value the refinery and the answer is no nobody has built a new refinery in the united states in 50 years but refinery capacity has increased 50 percent over that time at the margin therefore what's the most efficient way to reproduce refinery capacity it's brownfield capacity not greenfield capacity and that number is about eight thousand dollars per barrel if you know that you have a feel for what is going to elicit extra refining capacity in a way that the other side of the trade doesn't you can do it for intangibles a trained labor force a product portfolio and a book of business what would you have to pay an independent sales agent to generate this book of business what is good about doing that and starting there one it's reliable information but two it's information very few people on the other side of the trade are collecting and that's where you're going to start what's the second most reliable piece of information you probably have about the company it's what's its average earnings potential averaged over the business cycle taking out any accounting manipulations as it sits there today graham's word for that was the earnings power of the business it's a sustainable earnings level of the business as it sits there today and that's again something you can get your arms around because you're not looking at the future now you do have to project that into the future to get a value to convert that flow to a value you've got to multiply by 1 over the return that you require say one over ten percent but at least you're not subtracting the growth rate that's why this is less reliable than the asset value where does where do all the problems in valuation arise they arise from the growth so we're just going to ignore the growth for the moment we're going to look at the earnings power and we're going to look at the asset value and then we're going to see if it tells a story that's relevant to both what i'm going to look at in this investment and to what the value of the growth is going to be and the picture is going to look like one of these three things case a is a case where say i've got six billion dollars in the reproduction value of the assets they're earning 200 million a year and after tax sustainable distributable earnings at a 10 cost of capital so i got 2 billion in earnings power what's going on in that company and where are you going to focus your active research efforts well assuming i haven't mistaken a non-viable business for a viable business it's got to be bad management because this is a management that's taking 6 billion in assets and generating 2 billion in earnings what's the crucial question there for about the price at which you would buy this particular asset can you get rid of the management it's looking at the proxy and if you can't you're going to stay away from this one because does anybody want to hazard a guess as to what the value of the growth is in that first case it's negative it actually destroys value what about the second case where the two are about the same i've got six billion in assets 600 million in earnings worth six billion dollars that is exactly what i would expect in a competitive market because if i could generate 10 billion worth of earnings for 6 billion in investment in reproducing assets what would all the competitors in that field do they jump in they drive prices down or they cut up the market more finely they definitely drive profits down and they wouldn't drive stop entering until they've eliminated that extra value that's exactly what you ought to see in a firm operating roughly effectively in a competitive market and that is a story you can validate with the data what's particularly good about what i'm doing in this case that the other side of the trade is not doing and a dcf is not even close to being able to do i have two independent observations on the value of that firm that i can triangulate i have a balance sheet reproduction value and i have an earnings power estimate converted to an earnings power value and i know they ought to be the same now in some cases the asset value is going to be much more stable in the earnings power value that's things like natural resource companies where prices are all over the place and you've got stable much more stable asset values in other cases like you know slight manufacturing businesses say where you've got a lot of intangible assets the earnings power value because the earnings are going to be relatively stable is going to be more reliable than the asset value but in the latter case the asset value tells you how much asset protection you've got for those earnings in the former case the asset the earnings power value tells you is there a reasonable level of earnings that will support your asset value if you're looking at both those things and the other side of the trade isn't and the dcf calculator has no clue about any of these things you're going to be on the right side of the trade what's your guess as to the value of growth in that second case it is zero no matter what the growth rate is i don't have to worry about growth in that case i'm finished it's only in that last case which is the coca-cola case where the earnings power value is maybe 40 billion and the asset reproduction value is maybe 8 billion that growth is going to have value but what has got to be true of that case i mean first of all what's going to determine the value in the case of something like coca-cola it's are those earnings sustainable and that's going to depend on the economic situation of the industry which are those strategic factors that you can identify if it's not sustainable then you're going to sooner or later be driven to the assets so the critical question there is the nature of the economics of the business preferences don't matter you'll see preferences only matter to the extent that the growth rate matters because they're really embodied in the price they charge which then is embodied in the earnings power that they can extract so you don't even have to worry about a lot of that you'll see when we talk about doing that but in that last case the critical questions are economic and you'll do focused research on that and that's the only case where growth has value so by starting with this decomposition i'm now ready to talk about the least reliable estimate of value here which is the growth over there there are several things if you're going to buy growth in your investment lives that you ought to understand this is the drinking and driving activity of the investment world understand that the value of growth is least reliably estimated it's highly sensitive to the assumptions the data that we talked about indicates that these are the glamour stocks that people systematically over pay for it in the old days value investors wanted this investors wanted these the growth for free but at least when you do it you want to understand when growth produces value for investors and there are good things about growth and bad things about growth the good thing about growth is a growing income stream as those of you who get frequent raises no is more valuable than a flat income stream the bad thing about growth that everybody ignores is that it requires investment and that means that every given moment you have less of that income stream you can live off of and the question is where does the second outweigh the first and if you think about it properly the answer is pretty straightforward so i'm not going to look at a growth rate what i'm going to look at is an investment of a hundred million dollars in growth well if i invest that money in growth i've got to pay the people who provided it a fair return what's a fair return what it would take to attract that money voluntarily to this project that's what a cost of capital is i have to pay them a cost of capital and say that's 10 so the growth funded by this 100 million had better more than cover the 10 million a year that you have to pay those investors if you have a crappy management investing that money or you're investing it at a competitive disadvantage are you going to earn 10 you'll be lucky to earn five now you'll show growing earnings but the five million that you get on a five percent return if you subtract from it the 10 million cost of investment you've got a minus five million net value to that growth investment capitalize it it's minus 50 million growth that er based on investments that earn less than the cost of capital destroys value suppose i'm in a competitive market am i ever going to sustainably earn 15 percent on that 100 million no because people were willing to supply money at 10 entrepreneurs will take that money at 10 invest it at 15 all day long and they'll drive that 15 return down and that process of investing won't stop until the excess return has gone away so in that competitive market on average you will earn 10 you will pay 10 so you'll earn 10 million you'll pay 10 million what's the net value of the growth zero so i don't even care what the growth rate is in that case it's only in the last case where i earn above that 10 that i have to pay to attract the capital and i do it sustainably because there are structural economic barriers to competition entering my market that the growth has value well what do those three cases correspond to they're exactly the three cases that we started with the first case is the case where the assets are less than the earnings power value that's being generated it's the crappy management the management operating at a competitive disadvantage that case you want to stay away unless you're sure you can kill the management because they can eat up that asset value and trying to grow faster than you would ever believe and that's where value investors get in trouble they look at the assets they say hot damn and they forget that they've got these energetic but brain-damaged and self-serving managers busy dissipating it in growth as fast as they can in the middle case what am i going to do about the growth nothing it doesn't matter the growth doesn't generate any value i don't have to worry about how the ford motor company is going to grow because they're in a competitive market i just have to worry about the ford motor company's value today because the future investments are on average likely to earn just the cost of capital and they're not going to generate value it's only in that last case that growth generates value so the first thing that or the last thing in a sense that this approach to valuation does is it tells you which are the cases in which you have to worry at all about the growth and perhaps paying for the growth is there anybody here who thinks that a dcf will tell you anything like that or will enable you to do focused research and the answer is clearly no you're going to have a much better idea here of what you're paying for and what the value depends on than anybody doing a discounted cash flow obviously the next thing that you're going to be concerned with is what is it that constitutes a good business what a barriers to entry look like and here there is a massive amount of misinformation out there so one story that you hear all the time is that good businesses are powerful brands what do you think of as a what's the characteristic of a powerful brand it's prestige it's something where you will overpay to be associated with that brand in those terms what's the most power what are the most powerful brands in the world at this point all my mba students say coca-cola and i wonder how many of them are going to show up when they meet their in-laws for the first time and think they're going to impress them with a can of coke some of them even say walmart and i don't know a lot of people who spend a lot of time identifying themselves as walmart shoppers now in those brand terms it's clear it's the luxury car brands people talk about the rolls royce of this the cadillac of that the mercedes-benz of the other if you become a dictator of a country one of the first things you do is get yourself a terrific car and drive around in it you don't show up on a balcony with a can of coke or even with an apple ipod in your ears what's striking about those brands they're not particularly profitable general motors went bankrupt rolls-royce went bankrupt at a various point in fact if you look at the brands that are really profitable the coca-colas the colgate toothpaste the tide and the marlboroughs they're not strong brands in the traditional sense how many of you think coca-cola by the way is a global brand almost everybody the bad news is coca-cola makes 108 of its operating profit in 10 countries and all the rest of the globe they actually lose money so there's something else going on here beyond just branding oh what i do with my well there's something else that you always hear of and it's really something you ought to be warned against because it's the thing that generates a lot of the misplaced excitement people talk about first mover advantages if you actually look at the history of first movers most of them get slaughtered microsoft is not the first mover in pc operating systems it's actually a company called cpm visicalc did spreadsheets they were driven out of the market by lotus one two three they were driven out of the market by microsoft apple was driven out by ibm was driven out by compaq was driven out by dell it's very rare that the first mover survives so it's not about getting there first so if you think that's going to do it all the empirical evidence is you're wrong now the other model for defining good businesses is and i don't know how many of you are familiar with this is michael porter's five forces how many people have been exposed to that he's a famous business strategist he sort of categorizes markets by a list of five forces what's the fundamental problem with five forces it's four forces too many and it's a waste of time in practice now why do i say that with such confidence if you've read his book the first chapter is all about the five forces the second chapter is about generic strategies low-cost strategies and niche strategies what's striking is those two chapters have absolutely nothing to do with each other so when he actually came to think about strategies the five forces just justifiably and fairly went out the window so if we want to think about a good business the sensible way to think about it is to start by thinking about a bad business this is the one that i hope does not give people a free zone of horror because it comes from your freshman microeconomics course commodity businesses are bad businesses why because if you have a period like the top picture where the level of the price in the market gives you an opportunity to produce at outputs where the cost that is the average cost is below the price so you're making a pure economic profit at those outputs reporting profit rate returns on equity of 15 20 or so percent what happens next in that market people start to enter to take advantage of those returns mostly their existing competitors expanding as they enter what happens to the price gets driven down and first it gets driven below the minimum cost point for the inefficient producers and then it's only the efficient producers who survive these are markets of relentless competition actually i'm going to share with you a piece of wisdom that's going to be probably the most valuable of the night in practice of course it doesn't stop at the minimum average cost people put in the capacity and the capacity stays now how many of you have kids okay those kids are going to want pets what's the most important thing to know about the pet decision just like it is with the capacity decision it is a lot more fun to buy a kitten than to drown it later if you buy that kitten you are stuck with it trust me once the capacity goes in in these markets it tends to stay in these markets for a long time so you spend long periods of sub-market returns then there are exciting returns but on average these are not good businesses to be in so what do they tell you in sort of your first level business school course to do if you find yourself in this kind of business they tell you to differentiate your product turns out that won't do it because if you think about what a differentiated product does for you it looks a lot better than just being given a price you face a demand curve you can charge a high price and sell a few cars or a low price and sell a lot of cars but suppose we start with the upper picture where the demand curve is where it is and they decide to sell at a price where that first far out star is and their price which is what they make is above their average cost so they're going to be reporting and i'll give you the general motors number in the 1960s general motors made 46 on invested capital what happens next though in that industry say it's luxury cars the europeans look at that market and they say i have that technology i have access to those customers i can do that too and they enter that market now as they enter that market the price may not go down but at the old price what happens to the number of units general motors sells it goes down so what's happening to their unit fixed cost it's going up their variable cost isn't going down their price isn't going up what's happening to their profit margin per car it's going down what's happening to the number of cars they're selling it's going down their profits are shrinking in the 1970s their profit margin was 28 what happened next in that market the japanese looked out at an acura in infinity and lexus entered and when does the entry stop it stops when the profit opportunity goes away it's exactly the same as with the commodity product it's just that you get undermined in a very different way they divide up the market more finally drives up your fixed cost and that's what eliminates the profit opportunity but the profit opportunity as long as there are no barriers to entry is going to go away so what is fundamentally a good business have to be it's a business protected from competition on a sustainable basis and it turns out that those businesses have easily identifiable characteristics it's not rocket science it's not slogans like first mover advantages one you can have a cost advantage proprietary technology or you could have access to cheap resources do chinese manufacturers have competitive advantages because they have access to cheap resources no why do you care about your weakest competitors or your strongest competitors who are the strongest competitors for chinese manufacturers other chinese manufacturers and people in vietnam and other places everybody has potential access to cheap resources sometimes people will say oh i have deep pockets trust me the internet boom proved everybody had deep pockets the people who wind up think who start out thinking they've got deep pockets wind up with deep empty pockets if they compete at disadvantages so it's not access to resources it's unless they're very specialized unless you own madonna when she was young and stupid and you've got her for 10 years under contract so in general on the cost side it is all about proprietary technology does ford have a technology that the other big auto companies can't match either due to learning curves or patented products or patented processes and the answer for that is typically no on the demand side again it is not high demand the crucial thing is keeping competitors out it's not brands it's brand loyalty it's denying those customers to the potential entrance and what is it about coke that makes it a powerful brand in that sense that rolls-royce does not have repeat purchase coca-cola customers are fanatically loyal marlborough smokers are fanatically loyal it's very hard to get them to switch when you decide to buy a new luxury car do you automatically buy a mercedes benz no you go to a dealership you get fawned over you're going to switch cars anyway so there's no switching cost you don't buy out of habit you're not captive to anybody else on the demand side it is customer captivity but what is ultimately crucial because customers die and technologies die is that you have advantages in the markets for new technology and new customers that means you have to dominate those markets you have to have economies of scale so in those 10 countries where coke makes all its profit why does it make the profit because it dominates distribution and distribution is a huge fixed cost in those markets and it can offer lower prices and it can advertise more in those geographies than its competitors so it can recruit new customers on a favorable basis why has intel dominated pc you know cpu chips for 15 to 30 generations now because the big pc manufacturers will stay with intel if it has a comparable product if advanced micro devices or ibm produces a good product they may be able to get 20 percent of that market intel will get a hundred percent of it that means intel can outspend amd and ibm by five times in that market and given the economies of scale and research and development who's going to win the race for next generation ships pretty much all the time it is ultimately therefore for sustainability you want economies of scale in economist language the only sustainable monopolies are natural monopolies what that means is that when you look at these markets since economies of scale are determined on a market-by-market basis you have to look at these businesses on a market-by-market basis what that in turn means is that big global markets are essentially impossible to dominate why because in big global markets a guy can be viable with two to three percent market share there's no way you're going to keep them out at that level in a small local market with infrastructure costs or network effects that give you significant economies of scale an entrant may have to get 20 to 30 percent of the market to be viable and that you can prevent an entrant having if you've got some degree of customer captivity so ultimately what good markets are what good businesses are is their businesses that dominate markets and they're going to tend to be local markets and you see that by the way in the history of geography where walmart understood that and kmart and circuit city thought they were going to go all over the world and didn't in the cell phones where it's the local the dominant old baby bell cell phone companies that won the fight not the ats and the sprints or the the deutsche telecom which are global if you look at the pc industry who are the people who wound up making all the money it was not the apples and ibm's who did everything or the japanese who tried to do everything in ships it was the focused companies oracle in databases google in search intel only in cpu chips adobe and fonts and microsoft initially by the way just in operating systems and then they expanded around the edges with their competitive advantages applied so good businesses have two characteristics they dominate local markets and they understand that to make money in growth they have to grow either within those markets or at the edges of those markets where their local competitive advantages carry over what does that mean about eddie lampert and sears he's a famous investor who bought sears he brought kmart first and merged it with sears once you knew that he brought kmart out of bankruptcy in 43 states it was all over because he wasn't going to dominate any of those states the old walmart started in the upper middle west its headquarters were in detroit it dominated that geography and then they got stupid they decided that they were going to be thinly dispersed all over the united states and walmart ate their shorts one region at a time so good businesses think small and think locally either in product space or in geography and that's the key to what these value investors like buffett understand about those businesses now it is still the case that they are not easy to value but at least you have a principle to apply and i'm going to close to finishing here if there are no if it doesn't dominate a market it doesn't have this kind of profit potential to and the potential to erect barriers to entry you're going to do asset value earnings power value and you're going to be finished if it does dominate a market actually you have to do things entirely differently and i'll give you a flavor for it because i'm running a little late and i don't want to keep you here too long what you've got to do is recognize what the valuation problem is which is when you're doing growth companies the underlying parameters are related to value on a very steep part of that curve so very small errors in estimating growth rates and cost of capital lead to huge errors and estimates of value and you'll talk yourself into almost any stupidity if you do that it's like a dcf so what you've got to do is not look at it in value space and this is what buffett and other people do that they'll never tell you about look at it in return space say at today's price what kind of a return could i expect from this investment and that involves simply being careful about what your return is coming from that you want to verify that it is in fact dominating a local market it's got a history of above cost of capital returns and share stability in that market sustainable competitive advantages start with the earnings return just divide the sustainable earnings either per share or generally buy the price and say that number is you're paying 12 times sustainable earnings it's basically an eight and a half percent return next ask yourself how much of that return are they distributing to you so walmart for example trades at about 15 times earnings which is about a six and a half percent return the dividend is about two and a half percent start there the dividends plus the buybacks the fraction of that in my example eight percent that they return to you say it's half you got a four percent cash return then what do they do with the other four percent they invest it and you ought to investigate carefully where the money is going and if they're not earning above the cost of capital if it's walmart that's expanding in germany or korea at a competitive disadvantage to the local locally dominant retailers they're not going to make any money if they're building stores within regions they already dominate using their existing infrastructure turns out you can calculate that return it's about 18 versus a 9 cost of capital every dollar they invest there is worth two dollars so look at the average return in that investment program and divide it by a simple estimate of the cost of capital they're earning 15 and their cost of capital is 10. every dollar of that four percent they reinvest is worth a dollar and a half so that's worth six percent so you have four percent cash six percent for reinvestment and then you've got organic growth that you get for free where does that come from just gdp growth what is it for walmart it's close to zero start with gdp growth in the us of four percent and there are two things you want to look at one is this rich people or poor people or working people if it's rich people they're going to grow faster than gdp the demand if it's working people a lot slower so subtract three percent because walmart is working people then at the margin people spend money on goods not services walmart sells goods by and large it's worth another half a percent off so they've maybe got a half percent organic growth that requires almost no investment because it just requires inventory that's offset by accounts payable so you've got a cash return a reinvestment return and an organic growth return there are stocks out there like nestle that are incredibly safe where that number is about 11 to 12 and you can look at the history and you can look at what they're doing and that's a reliable number it's much safer if you look at their what happened to them in the commodity boom it's nothing if you look at what happened to them in the crisis it's nothing it's an above market level of safety for a 12 return that's a sensible decision you can make to buy and you can do that for all these stocks but there is a residual problem that you have to know about that even the gram and dot approach won't save you from which is when you sell these stocks you have to pick a price and because you can't put a value on them precisely you can't do a very good sell decision what's buffett sell discipline he never sells it's really stupid in some cases it's another famous investor named seth clarman he never pays above 20 times earnings it's really stupid in some cases but you got to have a rule you're not going to be able to do this precisely but what you want to have a sense of is that this approach asset value earnings power value is it a franchise business if yes then you're going to worry about the value of the growth and you're going to look at it in return space i guarantee you is going to tell you a lot more than what you're going to get out of a discounted cash flow and to the extent that all the business schools continue to teach discounted cash flows this is going to put you on the right side of the trade there it also is going to enable you to do focused research because it identifies the critical parameters and doing focused research efficiently is a critical part of an investment process you also want to look at the collateral evidence and if you do all that really well there may not be that much risk to manage on risk management i just want to say two things one is you cannot decentralize it you have to do it yourself why because if manager a is insuring against risk b and manager b is taking on manager b is taking on risk b the two net out and you're paying them both fees for the same thing the very first job that i ever did in finance was looking at the at t pension funds they had 200 managers or a group of us at bell labs that did it the first thing we did just to see what was going on as we asked in any given week how much of what one manager was buying was another manager selling and what do you think the number was with 200 managers it was 90 percent and the reason it was so low was that there was always money being put into the funds of the incremental investments 93 was just buying the market so you were paying 75 basis points in fees and another 75 basis points in transaction cost which is one and a half percent for managing seven percent of your portfolio and actually only ten percent of that so the same thing applies to risk management you want to do it centrally and you want to look at there are basically three things you want to do to prevent permanent impairment of capital one you want to be careful when you buy you got to stay away from the exciting times and the exciting stocks nothing will impair your capital faster than paying a dollar for something that's only worth 50 cents it's gone at the purchase decision second thing is you have to be diversified these cheap stocks lots of them go bankrupt you can't have one or two stock portfolios and three you've got to stay away from leverage because it'll turn temporary losses into permanent losses so if you have a good search strategy specialization plus ugly and cheap you have a good valuation approach which is basically a gram-and-dot approach you do focused research you're careful about your own mistakes and you manage risks to make sure you don't permanently impair capital you won't be as rich as warren buffett but i guarantee you on average you'll do a lot better than the person on the other side of the trade i think i've much more than used up my time but if anybody wants to stay and ask questions i'll stay here thank you for your attention i don't want to hold the whole group up just for the individual questions so why don't you come down and ask them okay

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Keywords: bruce greenwald, bruce greenwald interview, bruce greenwald value investing, columbia business school, bruce greenwald competitive advantage, bruce greenwald warren buffett, columbia university, bruce greenwald valuation, bruce greenwald investing, dr. bruce greenwald, bruce greenwald modern value investing, value investing principles bruce greenwald, bruce greenwald stock market, greenwald, ivalue investing, yt:cc=on

Id: 3DdY0JdUilM

Length: 83min 0sec (4980 seconds)

Published: Wed Jun 30 2021