An Introduction to Value Investing - confronting value traps

Fundamentals 01: Originally published under "An Introduction to Investing in Listed Companies".  Cover issues to consider when investing.  Updated to include notes on how to analyze companies and other value investing tips. Revision date: 18 Oct 2020


Intro to Investing in Listed Companies
"Investment is simple but not easy" Benjamin Graham

If you want to invest in listed companies from a value investing perspective, but do not have the time or knowledge to analyze and value the companies, join me as I share my analysis and valuation of such companies. I hope to short cut your learning journey. 

As a value investor, you would be investing when the price is at a significant discount to the intrinsic value. The question then is whether your assessment of intrinsic value is accurate.
  • If your valuation is wrong, then the stock is really cheap for a reason and you have a value trap.
  • But if your assessment of intrinsic value is correct, then you have a bargain.

From the above perspective, value traps and bargains are two sides of the value investing coin.

More importantly, value investing is about confronting the value trap question. Value traps are fundamental to value investing. 

Following this perspective, you have to develop 3 skills if you want to be a successful value investor
  • How to analyze companies that I will discuss here
  • How to value companies that will be covered in Fundamentals 02
  • How to mitigate risk which will be covered in Fundamentals 03

Contents

  • How I got started
  • What to consider at the start?
  • What to buy?
  • How much to buy - position sizing
  • When to buy or sell?
  • Valuation - the means to confront value traps
  • Company analysis - the building blocks for assessing value traps
  • Pulling it all together


How I got started

I first started investing in companies listed on Bursa in the early nineties. Yep! I did not start early.

Actually, I had no sound basis for selecting the companies to invest in then. Needless to say, I only earned about what I would have earned if I had kept my monies in fixed deposits. Luckily, I only had a very small amount invested then! 

It was about 15 years ago when I decided to look at investing in equities seriously i.e. as a way to generate better returns. So, I started to learn as much as possible about how to invest by crawling the web. 

There are lots of information on the web on how to invest and value companies. In hindsight some of them are nonsensical. Unfortunately for a beginner, it is hard to tell which is the appropriate approach. 

I guess it took me several years to finally weed out the “rules of thumb posing as theory” from those that had some theoretical foundations. And this was only after spending time learning from several investment and valuation textbooks. 

It took me even longer to come to the conclusion that value traps are fundamental to value investing. You are looking for bargains and the challenge is to find the real bargains.  The false ones are value traps. 

With this insight, I began to categorize bargains into
  • Those based on growth - the Compounders
  • Those based on assets - the Net Nets
  • Those based on quality - the Quality Value
  • Those based on distributing profits - the Dividend yielders

You wouldn't want to know the RM cost of this learning curve.


i4value: What to consider when investing


What to consider at the start?

Before we dive into the process of value investing, there are a few questions about investing that all beginners ask:
  • Why invest?
  • Why value investing?
  • What drives the stock price?
  • Is it gambling?
  • How much should I invest in stocks?
  • Can I make money?

Why invest?

The main goal of investing is to protect your savings from the ravages of inflation.  You also grow your wealth in the process.
  • To achieve the former, you need an investment approach that provides a return that is above the inflation rate
  • To achieve the latter, you need to harness the power of compounding.  But compounding requires consistent returns over decades of investing

I have found that value investing enables me to generate consistent returns that are above the inflation rates.  

At the same time, I have been a “serious” value investor for only 15 years.  I need another decade or two to compound my net worth. 

Why value investing?

There are 3 critical issues in investing
  • What to buy – the valuation thesis
  • How much to buy – positing sizing and portfolio construction.
  • When to buy or sell

Value investing provides a good way to answer these three questions
  • You buy when price < intrinsic value
  • You buy more for those with the highest conviction
  • You sell when price > intrinsic value

This is not to say that other investing styles are not able to provide the answers

There are many investing styles eg technical, quants, factor, indexing.  Each one of them will have their proponents and their own way of answering these questions. 

Investing is a zero-sum game.  There are two sides to every transaction and when you buy a stock thinking that it will go up, there another party on the other side thinking the opposite.

So the question is who is right?

I would like to think that since with value investing, I am buying a bargain, I am on the right side of the trade. 

What drives the stock price?

What drives the stock price?

Technically supply and demand determine the stock price whether in the short term or long term.

But the supply and demand for a stock are derived items. I used the term “derived” because they are dependent on the outlook for the stock

The outlook is a function of sentiment and the company’s fundamentals. In the short run, sentiment rules but in the long-run fundamental rules.

The challenge is that sentiments are also influenced by fundamentals.

You will realize that two main investing styles have developed because of this:
  • The technical one that tries to capture the sentiments by looking at price and volume signals
  • The fundamental one that tries to relate the price to the business performance

Generally, the former tends to be short term focussed whereas the latter is better for long term investing.


Is it gambling?

Gambling is an activity that depends purely on luck. Buying a lottery is a gamble. So, playing the one-arm bandit or the roulette in a casino is gambling. 

But there are some activities that while appearing to be a gamble requires some degree of skill. I am sure that the professional poker player will say that poker is such a game.

When it comes to the stock market, there are those that invest blindly hoping to get rich by luck.  But you need skills to be a successful value investor.  Of course, a bit of luck helps.

When you have an activity where skill is required to win when played regularly, I would not consider it gambling.  Investing in the stock market is one such activity. Just because there are those that blindly invest hoping to win by luck does not make the game a gamble.

Using the gambling analogy, if you are a skillful investor you are acting as the house in a casino where the odds are stacked in your favour.  If you don’t develop your skills and invest as a novice you are likely to be like the guest in the casino.

How much should I invest in stocks?

You should consider your investment in stocks as part of your asset allocation or investment plan.

If you know how the future will turn out, you will be an idiot not to invest all in the asset class with the best return.

The reality is that we don’t’ know which asset will deliver the best return.  So, we spread our net worth among many assets.  If one asset class does badly, hopefully, the others will do well enough to offset the bad performance.

What you set aside for stock investing should be seen as part of your asset allocation plan. 

Asset allocation is a wide subject and is covered in another post. 

Can I make money?

You invest to protect your saving against inflation and hopefully grow wealth.

Can you be successful?  

If you look at all the successful investors, they tend to focus on one particular investment path
  • Warren Buffet made his fortune from value investing
  • Cliff Asness of AQR Capital is a well know quant
  • Thomas Price Jr is known as the father of growth investing
  • Jesse Livermore is a well-known trader

If you want to be successful, you have to be an expert in your chosen path. You must acquire the appropriate knowledge and learn how to apply it through case studies and paper transactions.  Once you have mastered it, you can then invest with real money. 

You may worry that with so many professional or institutional investors, you will have a hard time making money. 

As a retail value investor, you have certain advantages over the institutional or professionally investor
  • You can have a contrarian view without having to worry about losing your job
  • You can have a long-term investing horizon
  • With a smaller amount to invest, you have choices not available to the larger funds

I would think that if you really master the investing skill you have a good chance of making money.

You make money if you know what you are doing. 


What to buy?

What to buy?

I follow 2 key principles in deciding what to buy.
  • Buying at a discount to the intrinsic value. This serves both as risk mitigation as well as provide the upside
  • How to protect against a permanent loss of capital i.e. risk management

Ya. In layman terms - buy a bargain and don't lose money. 

I am sure that when you start to analyze a company, there will be tons of information many of which are nice to know, but not critical in investing. To narrow down the analysis and valuation, I classify my investments into the following:

1) Compounders – these are high returns and growth companies where I hope to benefit from the growth in intrinsic value. 

Generally, they will be trading at greater than book value and any Earnings Value (EV) model would not capture their full value. In such instances, I look at returns as the valuation metric.

2) Quality value – these are companies with above-average Q Rating where the market has not recognized their real worth causing them to trade at discounts to their intrinsic values. 

I would only buy if the market price is at least at a 25 % discount to the EV.

3) Turnarounds – these are companies facing some temporary issues. However, the market has priced them as if there is no hope of any recovery. 

The main challenge here is valuation as any historical EV may not capture the value after the turnaround. 

4) Net Net – these are companies trading at a discount to its Graham Net Net value. They may or may not be facing turnaround issues. Like the Turnarounds, the challenge here is to ensure that they are not value traps. 

5) Dividend Yielders – these are companies that are purchased mainly for their dividends. Examples are the REITs.

The above classification serves the following purposes:
  • All valuation involves assumptions about the future.  One way to handle the uncertainty is to have a margin of safety. The various types of investments have a different degree of uncertainty. I am more confident about the intrinsic values of Net Nets than the intrinsic values of Compounders.  I thus have different margins of safety for the various type of investments. 
  • Having various categories of investments is one way to diversify the portfolio
  • It helps to focus on the type of valuation method to use.  Compounders and quality value companies are better valued with earnings-based methods.  The value of Net Nets is based on asset-values.

You will realize from the above that my decision on what is a good stock to buy is then dependent on the reasons why price < intrinsic value.
  • It does not matter whether it is a penny stock or whether it is the highest-priced stock 
  • It may require contrarian thinking as many of the stocks I choose are not the popular ones 

How much to buy - position sizing

So you have identified what to buy. The next issue then is how much of it to buy - what is referred to as positioning sizing. 

There is a relationship between the 3 key parameters in a portfolio
  • The total amount to be invested for the portfolio
  • The number of stocks in the portfolio
  • The amount to be allocated to each stock ie the position size

These 3 parameters are linked. Given the total to be invested, the amount you allocate to each stock affects the number of stocks in the portfolio. 

For example, if you have RM 100,000 to invest and you decide to allocate RM 25,000 to each stock, you will end up with 4 stocks in your portfolio. 

Position sizing and portfolio construction are part of risk mitigation. Every stock has both risks specific to the company as well as general market risk. You can mitigate against specific company risk by holding a diversified portfolio of stocks. 

The theory suggests that you can reduce most of the risks associated with individual stocks by holding about 20 to 30 companies. What remains then is the general market risk which cannot be diversified away. You will have to consider other measures to protect against market risk. 

Given the total amount to be invested and the target of about 30 companies for a diversified portfolio, you can now determine the amount to be allocated to each stock.

In terms of portfolio construction, I am a bottom-up stock picker. My portfolio is made up of companies from the 5 categories of stock as per above that was independently purchased. 

In other words, I do not pre-determine the number of companies from each category or sector for the portfolio. 

Having said this, I limit the exposure to any one sector to 30 % of the total portfolio value. We cannot be too careful. 

When I first started, I allocated about the same sum to each of the companies in my portfolio. Then I came across the Kelly formula. 

Although you cannot apply the formula literally as the formula relies on repeatable probabilities, you can use the principle that the optimum investment is one where you invest the most in the company with the best probability of success. 

It simply means that you should allocate larger sums to those which you have the most conviction. 

In practice this meant that you allocate larger sums to companies meeting a combination of the following metrics:
  • Highest dividend yield
  • Higher Q Rating
  • Higher margin of safety

Given the total investment sum and a target of 30 companies in the portfolio, you then come up with the amount to be invested in each company.

When to buy or sell?

So you have identified what to buy and how much of the stock to invest in.

When do you really execute the trade?

You will find that in many cases, I generally take some time to build-up to the invested sum
  • I have found that when you have actually committed money to an investment, I become more focused on assessing the company.  This is probably a behavioral issue but because of this, I have learned to build up my position over a 3 to 6 months period
  • Secondly, to ensure that I get the lowest price, I do use some technical indicators to provide some insight into whether the price has the potential to go lower.  I look at candlestick patterns and trendlines.  
  • To clarify, these technical indicators are used to “time” my entry and exit after I have made the decision to buy or sell based on value investing principles.  I do not use technical signals to decide on whether to buy or to sell.   
  • Like the entries, I seldom exit a stock in one go but rather spread it over several batches.  This is to get a balance between selling too early and regret not selling when the price collapse after running up. 

Although I am a long-term investor, it does not mean that I never sell my shares. I have sold under the following conditions: 
  • When the market price is > 20 % of the computed intrinsic value. However, in a range-bound market, this criterion is modified to sell when the market price = computed intrinsic value. You guessed it - I want to realize my gain
  • When the investment thesis is no longer valid either due to changes in the market and/or errors in my assumptions. This is a cut-loss strategy. Have some money to fight another day. 
  • I also sell if, after 7 years of investing in the stock, the market persists in the mispricing. The logic is to allocate the monies for another prospective stock. The reality is that you can lose patience after some time so this is cut-off period will depend on your personality. 

To put the selling strategy in perspective, over the past 15 years about less than 5 % of my portfolio have been sold because of invalid investment thesis or long waiting period.

The majority have been sold because they have reached the targeted return.  My target is to achieve a 15% compounded annual total return.  I compute my total returns as 

Total return = (capital gain plus total dividends received) divided by the original investment

My track records are:
  • About 5 % of the stocks achieved the target within the first year of the initial purchase
  • About 5% are duds. 
  • The majority takes about 3 to 5 years to reach the targeted return
  • About 1/3 of the total returns comes from dividends
  • Overall, I achieve a total return that is about 2 to 3 % higher than the total return of the stock market index

What determines the holding period?

The Holding Period

There are 2 ways to grow wealth
  • Invest in a portfolio that you never sell because they are the companies that are able to increase shareholders' value over many decades.  Unfortunately, I do not have the ability to identify such companies
  • The other way is to start with a portfolio of undervalued stocks.  When some of the stocks become overvalued, you sell them and then reinvest all the monies into other undervalued stocks.  You then repeat the cycle for a different set of portfolio stocks

My track record with this portfolio strategy is that I have about 15 % stock turnover annually.  Another way to look at this is that on average I hold a stock for about 5 to 7 years.

To be able to execute this portfolio plan, you need 
  • To be able to find replacement stocks every year.  Thus, having several types of investment helps this strategy
  • You need an investment process the delivers consistent returns that in independent of the type of companies in the portfolio.  I find that value investing enables me to achieve this
  • You need patience. It is a plodding way to grow wealth. Effectively you are the tortoise in the race rather than the hare. 

The above explains why I am a long-term investor. 
  • It is because business fundamentals do not change overnight.  It may even take years for companies to turnaround.
  • It may even take longer for the market to recognize changes in business prospects
But there is another angle for being a long-term investor.  If you want to benefit from the power of compounding, you have to invest continuously for decades. 


Valuation - the means to confront value traps

Whether is stock is a value trap or a bargain is assessed by comparing the price with the intrinsic value.

The key then is determining the intrinsic value. 

There 3 general ways to value a company
  • Asset-based where you view the assets as a store of value.
  • Earnings-based where you view the assets as a generator of value
  • Relative value where you value the asset by comparing it to the price of a similar asset

I do not consider relative valuation an intrinsic valuation approach and so I use the following two  approaches
  • Asset-based valuation 
  • Earnings-based valuation 

OK, it is going to get a bit technical here. But I am just giving an overview and you can refer to the Definitions posting if you want to go deeper.


Asset-based value(AV)

Asset-based valuation focuses on the value of the company’s assets. 

There is a relationship between the assets of a company and the returns that can be generated from the assets.  

According to economic theory
  • High returns relative to the cost of funds will attract competitors and this will eventually drive returns down.  
  • If returns are low relative to the cost of funds, some companies will exit the industry and this will lead to better returns.  

The result is that in the long run, the returns would equal the cost of funds. 

In the context of valuation, I see the following:
  • If there are persistently low returns, it must mean that the assets are overvalued.  Expect some impairment so that the asset value will commensurate with the returns
  • If the returns persistently above the cost of funds, the company must have some economic moat to maintain this position.  In such situations, the intrinsic value of the company would be higher than the asset value ie the asset value serves as a floor value.

There are several perspectives under this approach from the Graham Net Net, NTA, Book Value to Reproduction Value.

How have I used the Asset-based valuation?
  • Occasionally I have found companies whose prices are below their Graham Net-Nets. Many consider Net Net as a proxy for the liquidation value. If these are operating companies, I would consider them as ones with a very high margin of safety and always ended up investing in them
  • In times of economic distress, there are many companies trading below their NTA and Book Values. This is a sign to focus my analysis of such companies
  • The assets and liabilities of financial institutions are generally marked to market. They already captured at prevailing market values. Thus any financial institutions with market prices below their NTAs deserve closer investigation.
  • And of course, the Asset-based value is used with the Earnings-based value as part of my assessment of the company’s performance.


Earnings-based value (EV)

Here you view the assets as a generator of value.  The intrinsic value is the discounted value of the cash flow generated by the business over its life.

The challenges here are then
  • Forecasting the cash flow
  • Determining the discount rate 
  • Determining the life of the business

In the Earnings-based method, the value of the company is determined by both the Residual Earnings method and the Free Cash Flow method. Yes, you probably have to read the Definitions

But no need to get too hung up on the definitions. I will do the calculations and take care of the reconciliations, etc.

In practice, I have found that are differences in the computed values from both methods. This is probably because the information for the valuation is extracted from different parts of the financial statements.

So I take the average of the values computed by the two methods as the final Intrinsic Value. 

Furthermore, I generally undertake the above valuation under 2 scenarios
  • Assuming no growth i.e the Earnings Power Value (EPV)
  • With growth
As the above method is just valuing the operating assets i.e. it ignores excess cash, investments, and associates. and other non-operating assets, the value of these non-operating assets has to be added in order to arrive at the total value of the company.


Triangulating the intrinsic value

All valuations are based on assumptions about the future.

Since we don’t have a crystal ball, to handle the uncertainty involved in the valuation,
  • I use both the Asset-based value and the Earnings-based value together with other valuation metrics to triangulate the intrinsic value
  • Having triangulated that intrinsic value as say $ X. I then factor in a margin of safety eg 30% so that the intrinsic value in the analysis is now $ 0.7 X.
  • I buy when the price < $ 0.7 X

In addition to determining the intrinsic value, I also use a number of other metrics that are used by other more experienced value investors.  These include
  • The Acquirer’s multiple 
  • The Greenblatt Magic Formula
Company analysis

Company analysis - the building blocks for assessing value traps

While valuation is an important element to determine whether is stock is a value trap or a bargain, it needs to be backed by a good understanding of the company's business.  This is the company analysis aspect of the investment process.

This is to ensure that the valuation exercise does not turn into a number-crunching one that does not reflect reality. 

That is why I consider the company analysis as the building block for assessing value traps.

Having being involved at the senior management level in running companies, I realize that there is not much difference in analyzing the business in the context of running it compared to analyzing it as part of the investment process. 

However, the focus is different – here you are trying to formulate your investment thesis and you want your outlook of the business and its valuation assumptions to be realistic. 

Accordingly, I frame my analysis to answer the following:
  • How did it get here?
  • How does it make money?
  • Where is it heading?

Items such as products, corporate structure, management style, and shareholders are background information.

Apart from looking at the business per se, I also spend considerable efforts to understand
  • Management performance and 
  • The key business risks.

While knowing the importance of management in driving the business, the challenge is how to evaluate them as you are not able to meet with them as a minority shareholder.  

I try to present an objective picture of management by looking at the following
  • Are they owner-managers?
  • How long have they been with the company?
  • How have they performed relative to their peers?
  • How have they allocated capital?

When it comes to risk, my analyses and valuation are based on a long-term view of the business. I try to identify and assess those factors that will affect the long-term prospects of the business.  You can consider these as strategic risks. 

My view is that as a minority shareholder, you are not management.  Hence you leave all the operational and other short-term risks to management to resolve.  You thus try to look at those risks that will change the nature of the business. 

Take analysts' reports with a grain of salt

When you start to look at companies, one of the sources of information will be the analysts' reports. 

Over the years, I have read many research houses reports on Bursa listed companies. Analysts are warned. I am going to say things unpleasant about your profession. 

I do not find many reports to be very informative as what is presented in the report can be picked up from the company’s announcements. 

Secondly, many Malaysian analysts seemed to focus on what companies are going to do over the next one to two quarters. While they all say that they have a long-term view of the business a significant part of the report is dedicated to what happened in the last quarter and the issues faced currently. 

Furthermore, many analysts provide a target price for the company featured. I must admit I do not understand the logic of the target price since most analysts (except those providing technical analysis) claim to be looking at fundamentals. 

Setting a target price seems more like forecasting what the market will do – there is a disconnect as the analyst report is on the company’s fundamentals yet the analyst somehow jumped from such fundamental analysis to forecast the market price. 

There is then the question of valuation. Most analysts use the market multiple methods to value the company featured. Very few determine what I consider as the intrinsic value of the company. 

Pulling it all together

  • There are many investment styles, from one based on fundamentals as summarized above to those based on technical charts. There are also those who trade frequently to those that invest in the long term. 
  • I invest as a value investor because it puts you on the right side of the transaction.  It provides a way to answer the 3 basic investing questions
    • What to buy
    • How much to buy
    • When to buy and sell
  • All value investors have their own beliefs that drive their answers to the value trap question – what many refer to as the Investment Thesis. You build the Investment Thesis based on business analysis, valuation, and risk mitigation

Honestly, this is a process that continues to evolve. Every now and then I tweak the process. So if you find loopholes in some of what I said, feel free to comment. 




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Disclaimer
I am not an investment adviser, security analyst or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned in this website may not be suitable to you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

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