Thus prices move around more than value.
• Mr. Market is crazy
But there is no translation into action for many investors including smart MBAs. Gotham Capital has compounded capital at 40% per year. He just does the obvious. Why has he outperformed if: 1.) he can't value better? 2.) He is no smarter than others?
Because of the way he looks at the world and his ability to wait for good risk/reward opportunities. Simplify things. If your valuation is good--that is the key. If he can't value, then he walks away. If he can't
figure it out, he walks away. Swing at fat pitches. If it is hard, then pass.
Greenblatt will invest in technology like when those companies had tons of cash and he could buy the business for free.
A good book: Stocks for the Long Run by Jeremy Siegel
Why don't smart people from Columbia Business School and Wharton do better? They get confused - They put value investing in the context of efficient markets.
In one year you have a 2/3 chance of losing 8% or gaining 28% if you hold for less than 1 year.
In 1996 Richard Pzena under performed the market and lost clients, yet he was doing what he always was doing.
3 to 5 years is his minimum time horizon. This is the most inefficient part of the market.
In 1999 value was dead. For 4.5 years, there was underperformance. Oakmark fired their manager and
brought in a new guy who kept doing the same thing and now is doing great.
Value investing doesn't always work, because if it did, then it wouldn't work. (This contradiction makes
investing very difficult because of the persistence, patience and discipline required).
Look at special situation investing - uncovered areas, a different way of looking at the world. Keep the context.
How he sees the world. Now he owns three stocks - concentrated. He is not leveraged. He believes that the market will eventually get it right. The market can often present extreme values.
Special situations - Time frame involved, not sophisticated. Bigger pick. Buy a company for 4.5 x EBIT, the business will do OK.
Also, the way we conduct our portfolio. How we view risk is different than the norm.
This course is about what I know. Basics of finance and accounting. This is the course I wish I had while in
business school. Find things worth a dollar and pay 50 cents for it—Ben Graham’s philosophy.
The press is depressed because something bad happened, people are worried about it. What will it earn two or three years from now? Most focus on the short term problems versus the long term return.
When the smoke clears, what will it be worth?
Ben Graham: Buy for 50 cents a crummy business, but now the $1 is worth 75 cents. The danger with buying “cigar butts” is that time is the enemy of the bad business.
Value your businesses and assume it will pay you. Estimate of growth, but don't know way.
Concentrated portfolio. Gotham returned all outside capital and stayed small. Money Managers focus on next quarter.
There are different ways to value business. Triangulate or cross-check your work.
• DCF Analysis.
• Relative Acquisition Value.
• Break-up value (real estate).
Acquire value - discount brokerage has 100,000 clients but worth more to another brokerage firm that has 500,000 clients. Consolidation of clients means that a strategic buyer can pay more.
Flaws with Each Valuation Method
1. Intrinsic valuation – Discounted Cash Flow (DCF) has flaws, small changes in inputs lead to huge swings in valuation. Use when the business is very stable and you should be very conservative (in your assumptions of growth and discount rate).
2. Relative value - P/E similar, but other public companies are overvalued. Most acquisitions fail. Pay only 1/2 of 250 x earnings. Not comparable - industry consolidating.
3. Break-up value. One division is earning $3 per share while the other loses $1 per share. So $2 per share and if the stock is at $33, then it trades at 17 times EPS. 11 x EPS if – ($1.00 close down our loss division) has flaws.
So we use several valuation methods to cross check. Use conservative assumptions.
Use a long-term bond yield. $1/EPS at 16.66 xs vs. 6% long bond. Compare a growing dollar vs. a certain dollar. 6% from govt. bond, but if $1 grows then good. If the current long bond (Feb. 2005) is 4%, use 6% at least as a minimum hurdle rate or discount rate. Have a margin of safety.
$10 ----$1 EPS now but normalized earnings show $0.50. Do you rather own a risk- less bond or this? Is it going to grow or not?
A complicated capital structure: buy 1/2 cash value and a good business.
Value Investors' Club (VIC). 1/2 are professionals. The rest are sophisticated professionals in finance.
There are good write-ups. Why cheap?
Some turnover because each member must contribute 2 ideas a year, but less than 6. Review the application for VIC.
S.CN Sherritt STM.V JEF CAH HIF-U Groupe Bull Olympia GA $4.13 MSO BUL.FP
Next week: Income Statement, Cash flow and Valuation Work. Use EBIT not P/E ratio in your valuation work.
Read Chapters 12 - 13 & 17 from Hooke's Book. There are some areas in that book where I disagree. Duff & Phelps case study- $52
END
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Greenblatt Class #2
Jan 26, 2005 Joel will not be having a Feb. 9th class. Make up on Friday?
Next Class we will have Richard Pzena presenting his idea of FRE. Prepare FREddie Mac (FRE - NYSE) Summary: Balance sheet analysis. Good business and good price. Duff & Phelps Case Study. ROE vs. ROC. Today we will look at Balance Sheets, Income Statements, CFs as an investor.
Terms Abbreviations
Net Working Capital NWC or (CA - CL)
Fixed Assets FA
Current Liabilities CL
Current Assets CA
I. CASH
We said last week that DCF is theoretically the way to look at things, but it is difficult to estimate the cash collected over a long period of time. The problem is figuring that out. Using DCF is like using the Hubbell Telescope, one small change and you are looking at another galaxy.
1. Answer: A crummy retailer with negative cash flow but great real estate. The property is worth more than the DCFs of the retailing operations. Hidden Asset that can be eventually but uncertainly turned into cash flows. Future wealth creation
2. Another example: two discount brokers: 1 has 200,000 customers and (2) another broker that has 1,000,000 customers buys it. After the acquisition Broker 2 has 1.2 mm customers with same cost structure. Broker 1 is worth more to an acquirer who can drive operational improvement--mostly cost reduction. There is more value to a strategic buyer.
In general, DCF is theoretically the normal way to value businesses. If that is the case, then why bother looking at the balance sheet?
1. More cash on the balance sheet than is necessary. The excess cash is $5. How to value and deal with the cash? CF from cash (interest earned) an investor must separate from the operating business. Forget the interest income line.
2. How will management deploy cash? The $5 is not in your (the investor's) pocket. What are