Value Investing: From Graham to Buffett and Beyond

 In this blog post, I will be providing a book summary on Professor Bruce Greenwald's book Value Investing: From Graham to Buffett and Beyond (2021). In this book, Professor Greenwald explores the modern extention to value investing to successfully adapt with the changing economic and financial conditions.

Economy activity, which has shifted from industry/manufacturing to services, has seen greater value placed on intangible capital relative to tangible capital. Hard asset-based businesses are becoming less important. Professor Greenwald addresses this paradigm shift, showing us how to gain an analytical advantage, how to think about valuations and the way to quantify growth. 

Gaining an Edge by Specialisation

• Either by design or practice, investors must specialise. Specialisation is the the most obvious way to improve the odds of being on the ride side of the trade. Investors have generally performed better starting from a very narrow focus and working outwards. Warren Buffett in a classic example of this and has been more successful investing in insurance, banking, old media, and consumer non-durables than in other industries.Those who try to be experts in many industries, usually took quickly, tend to be the jack of all trades but the master of none.
• Specialise in a particular geography. Focusing on firms with a particular region is an advantage particularly for those who in invest in small to medium sized companies. For services companies, it is just much easier to monitor customers, suppliers, competitors, etc. It is also easier to gain access to management.
• Spend at minimum 1,000 hours or more to develop a decent working knowledge of an industry. This is the equivalent of at least a full year to achieve an adequate level of mastery. This has to be continuously deepened to increase specialisation and to keep up with developments.

The Existence of Value Anomolies

Since the dawn of time, humans have developed behavioural tendencies to help them with survival. However, some of these traits today cause that cause these opportunities to exist in the markets. Professor Greenwald simplifies them into 3 three tendencies:

1. The "lottery ticket" appeal. People are prone to overpaying, despite the unfavourably stacked odds, for the dream of getting rich quickly. In the world of equity investing, glamour growth stocks represent these lottery tickets.
2. Loss aversion. This is the direct inverse to the preference for lottery ticket. In moments of market melt downs, people are more inclined to react and sell without careful analysis to avoid further losses.
3. Overconfidence. People tend to embrace certainty and ignore alternative possibilities. This bias intensifies the overvaluation of glamour stocks. In bad times, people are overconfident in their pessimism, which leads to undervaluations. 

Discounted Cash Flows

Professor Greenwald characterises Discount Cash Flows (DCFs) as a method with several fundamental problems.

1. It ignores the balance sheet. 
2. Terminal value dominates the overall value.
3. Minor adjustments to inputs often creates a large range in potential valuations.

DCFs are good for projects/events over the short-term with greater cash flow visibility. These include takovers, corporate reognisations, bankruptcies, etc. 

 To make this process more superior, an alternative approach includes:

1. Including the balance sheet. 
2. Organise the components of value by reliability with which they can be estimated.
3. Make clear the assumptions for estimated levels and components of value.

Instead, Professor Greenwald teaches business valuation using a 3 element approach: Asset Value, Earnings Power and Growth. 

Asset Value 

Asset Value (AV) is the most reliable source of valuation data. 

If the company future does not look economically viable, use liquidation value.

If the company is a going concern, use reproduction cost. Reproduction cost is the sum required to reproduce the company. This requires adjustments of balance sheet items, recognition of costs that have been expensed over the years which have added to the cost required for a competitor to build the same company of exact calibre, e.g. R&D spend, marketing spend, etc. 

For products, converting R&D spending into a valuation of a company's product portfolio is most simply done by multiplying annual spending by the number of years of R&D embodied in the company's product line. 

Earnings Power Value

Earnings Power is the sustainable current earnings that are constant over an indefinite future. Earnings Power Value (EPV) capitalises this value by dividing this value by the cost of capital. EPV does not attempt to anticipate future changes in a company's operations. The formula equation for EPV is

EPV = Earnings Power × 1/R

where R is the constant future cost of capital.

Sustainable current earnings are earnings measured after making the necessary investments to return a company's operations at the year's end to the same condition it was at the start of the year, essentially like Warren Buffett owners' earnings. 

In this calculation, we will have to omit the following growth capital expenditure and non-recurring items.

To segregating growth from maintenance capex, Professor Greenwald uses the following calculation: 

1. Firm's Capital Intensity = Fixed Asset/Sales. Normalise over an appropriate time period. 
2. Firm's Capital Intensity × Growth in Sales = Growth Capex
3. Maintenance Capex = Total Capex - Growth Capex

This can be shown in an example below with some basic assumptions.

The way to calculate the sustainable operating earnings is to: 

1. Start with the revenue.
2. Multiple by an average level of operating/EBIT margins, ideally encompassing two business. cycles. Do not apply higher profit margins when margins are growing and vice versa.
3. Adjust for unconsolidated operations, e.g. investment in associates.
4. Calculate NOPAT by adjusting by the average tax rate, i.e. EBIT(1 - Tax Rate).

To reach earnings power, reduce NOPAT by the maintenance capex and adjust for any accounting distortions related to D&A.

 To calculate cost of capital, estimates can be used using the different asset classes available. The cost of equity using this method is based on the security markets line. If yields are 5% on investment grade (at least BAA rated) and venture capital is 13 and 14%, cost of equity is between 6 and 13%. The lower the rates, the lower the cost of equity. Based on this assumption, the typical range of values for the cost of equity can apply to companies of varying risks.

Low risk typically entails non cyclicals such as utilities and high risk typically entails cyclical and commodity type businesses. Having selected a cost of equity, a cost of capital can be calculated using the weights of the debt and equity components, adjusting the cost of debt for tax.

The final step in determining EPV is to divide the estimated earnings power by the estimated cost of capital. This value will essentially give you an enterprise value. To arrive at the equity value, net debt must be subtracted. 0.25 - 0.5% revenue should be considered as working capital and should not be included in net debt.

Growth

Great companies are the ones that can pay out cash to its investors even as it funds its growth and these companies are rarely priced favorably. They often represent get rich quick stocks for which many investors repeated overpay. However, with prudent and skillful application, these stocks can be bought.

Graham and Dodd never paid extra for growth. They based stock purchased decisions based on EPV and any growth was considered free; this was their margin of safety.

These are some points to consider about growth stocks: 

1. They are optimistically forecasted and therefore suffered from being systematically biased. Growth high flyers generally disappoint and slow growers exceed expectation. Do not fall into the pitfall of relying on projections.
2. Growth stocks will be usually overpriced when the companies do not have a competitive advantage. Strong growth does not necessarily ensure enduring compounded growth and creation of a moat. It will attract competitors that will in turn, erode growth and profitability enjoyed by a first mover; late entrants are not materially disadvantaged if there are low barriers to entry. Sooner or later, if every competitor will earn only its cost of capital at best. Without competitive advantages and barriers to entry, growth will create little or no value.
3. For a company to enjoy long-term competitive advantage and high profitability, a telling sign is when growth rates are accompanied by high and stable or growing ROICs.
4. It's not all about the growth rate. How much cash investments are required to support the growth? Growth in virtually every instance requires additional investments, and that investment must be paid for. The crucial question for determining the net value of growth for a company is the relationship between the amount of investment needed to pay for the growth compared with the additional amounts and timing of distributes that the growth may produce. Buffett uses the analogy to describe this concept, "a bird in the hand is worth two in the bush."
5. Growth that require no supporting investment is extremely rare.

An investment based on a firm's prospects for growth must satisfy the two requirements: 

1. The growth must create value. This means that they must earn more than their cost of capital.
2. Not all growth can be appraised with enough precision to permit an accurate valuation.

Therefore, always demand a margin of safety where the growth is only at a substantial discount from its estimated value to make up for greater uncertainty.

The 2 different markets where companies can enter and earn returns: 

1. The highly profitable market. In these markets, incumbents enjoy sustainable competitive advantages; this is the worst for potential new entrants. Profitability is the result of the sustainable competitive advantages that ultimately rest on economies of scale. This makes it difficult for new entrants to earn above their cost of capital. Any growth for a firm operating at a competitive advantage or one with low quality management will destroy value. i.e. if they earn 5% their cost of capital per year, for example, $5m, and the cost of capital is 10%, $50m worth of value is being destroyed every year.
2. A new market. Growth can create value for firms entering new markets where it can dominate in the future. Here, they have the opportunity to build out their sustainable competitive advantage and bring up barriers to entry.

 So when does growth create value? 

1. The value of organic growth that is driven by increasing market demand as distinguished from growth that is actively pursued by the firm. Only firms in markets protected by barriers to entry will organic growth lead to sustained value creation.
2. The consequences of other favorable developments, such as new technologies that reduce costs and lead growth in earnings even if they do not directly crease demand. The common ones are lower costs and innovations in marketing, and enhanced distributions that increase operating efficiencies.
3. The value of growth options, secondary opportunities that a company can pursue if warranted and avoid if unattractive. Without barriers to entry, growth avenues that aren't protected by barriers to entry have the potential growth benefits offsets by the negative effect of fierce incoming competition.
4. The consequences of market shrinkage as opposed to expansion. If a market is shrinking, economies of scales will decline, adversely affecting margins through operating leverage.
5. The differences between growth in core markets compared to growth in new markets.

1. Focus on core regions that a company already dominates and build a moat there, slowly building out around the edges.
2. Otherwise, enter markets where there are no existing dominant competitors who have both captive customers and economic of scale advantages. Firms seeking to dominate these virgin markets must be extremely disciplined - focus on one market at a time - and superb at the execution. 

 Questions to ask for growth when evaluating: 

1. Is EPV > AV? This attracts competitors until EPV = AV.
2. Does it operate in a market where it has sustainable competitive advantage?
3. Does it currently earn above its cost of capital?
4. Is it likely to make growth investments in current or adjacent markets to which its competitive advantage can be extended?

Franchise businesses are the companies that have EPV well above AV. This is summarised in the table below:

 

"Good" Businesses are the Ones with Competitive Advantages

There is no good businesses in a competitive environment with relentless change.

Good businesses steadily earn returns of 15-20% or more by these measures outlined below, well above the typical 10% cost of capital. These returns should increase than erode over time. Good businesses are also ones that grow: 

1. Return on equity
2. Return on capital
3. After-tax returns on capital

Great businesses do all of that without having to retain a lot of their earnings.

Profitability does not mean automatically mean highly regarded brands. Brands simply does not tell anything like the whole story about what constitutes a sustainable competitive advantage and therefore a good business.

First movers have been no better than companies with esteemed brands in achieving sustainable competitive advantages and the profitability that we expect from good businesses.

Any enhancements to a generic product or service without a protected differentiated difference will invite competition to come in, eat up returns until the EPV equates to the AV.

Sustained competitive advantages in the business world are therefore the exception rather than the rule.

To create this exception, Professor Greenwald suggests that there are moats which have differing degrees of strength: 

• Law: this is the strongest. 

Government privileges such as licenses, patents, copyrights, or other protections.

 

These are the cable franchise, broadcast television stations, telephone companies and electric utilities. These all enjoy exclusive local franchises. However, governments can sometimes regulate these entities so that there are elements of price and profit controls, hindering the opportunity to earn excess returns. 

• Cost: how good are management and does the business benefit from size? 

1. Cost advantage from economies of scale or proprietary technology. Proprietary technology is most useful in slow moving industries, whereas in fast, proprietary technology becomes redundant rather quickly.
2. Know-how. As an business gains experience, the entrants will always trail the incumbent in the necessary expertise it takes to make this efficiently. To would depend on who the incumbents are in the industry. The test here is whether the required technology, including the human-based skill, is accessible to the entrant on the same terms as it is to the incumbent. e.g. Mercedes has a good brand, but its ability to attract talent is no less than its peers. 

• Revenue/customer demand advantages: how do you keep your customers captive? 

1. Habit, usually associated with high purchase frequency. This is probably the most powerful, since it reinforces the habit with every purchase or consumption.
2. Search costs. If the cost of searching for an alternative to the existing product or service is high, customers will have an aversion to change. This is a form of loss aversion which takes the form of potential negative experience using a new product or service.
3. High switching costs. This form of customer captivity is also a form of loss aversion which takes the form of potential increase in error rates as the new installation is implemented.

Most common competitive advantages are regional or product line economies of scale equates to local share or niche. Geoff Ganon from Focused Compounding states location as the number one competitive advantage a company can have due to its ability to avoid global competition.

A competitive advantage ultimately defends its position depends on the degree of customer captivity and/or customer inertia (or the rate at which the customer habits are solidifying). 

Assessing competitive advantage includes the following assessment of the checklist items.

Quantifying Growth

Identifying these companies is half the task, the other half involves the valuation. 

Professor Greenwald argues that the intrinsic value of growth can not be calculated with enough accuracy to be deemed useful. Minor directional changes in inputs can cause significant margins of error. Instead, Professor Greenwald suggests using an estimated return from buying a growth security at its current market price, and comparing that to the alternative opportunity sets.

The key value-determining factors are:

1. Current earnings power.
2. Distribution-retention policy for earnings.
3. Organic growth rates in revenue and margins.
4. Net Working Capital/Sales. This is the amount required in net working capital to fund organic growth, i.e. if an additional $1 of sales requires $0.5 in additional NWC, an additional $5 dollars of sales will require $2.5 in NWC as an investment towards organic growth. 
5. Inorganic growth/active investment. The value creation factor is the return multiple on the undistributed earnings above cost of capital, i.e. 30% ROIC vs 10% cost of capital means the value creation factor is 3. The most difficult is the value created by active investment, although it is less significant for companies that regularly distribute 85% or more of their earnings, leaving little to invest. 

Once the total return is calculated, subtract the following to obtain a percentage figure for the margin of safety.

1. Franchise fade rates. This is the rate at which the moat fades over time. If the time to business extinction is 50 years, the annual fade rade is approximately 72/50 or 1.4%. For durable franchises like Coca-Cola, this might be 80 years. For more recent tech companies, it might be more brief at 15 to 20 years.
2. The cost of capital.

An working example of a fictitious company is shown below.

Assessing Management Performance

1. Achievement of operational efficiency both in controlling costs and in the areas such as marketing and product development. This one is by far the most important area. Achieving excellence in this area is like a marathon, where it requires constant attention to incremental improvement.
2. The strategy for growth, especially capital allocation, which should avoid growth for its own sake and focus on those opportunities in which growth creates value. On growth that produces returns above their cost of capital creates value.
3. Financial structure and the distribution of cash flow to investors.
4. Human resource management.

Closing

The migration of business activity from manufacturing to services has meant that the standard accounting measures are becoming less relevant towards calculating intrinsic value.

To a large degree, the assets of good and great businesses of today are mainly intangibles which comprise of product portfolios, brands, customer relationships, trained workers and organisational structures. These items are expensed and do not appear on the traditional balance sheet, making it important to consider when basing a firm's intrinsic value on assets, calculating a firm's sustainable earnings and its potential growth. 

The 3-elements to valuations can be summarised in the diagram below.

To justify reasons for purchase using the 3-element approach, the table below can be used as a guide.