Can we learn anything from investment case studies?

Case Notes 01: Pointers from Ekson Case Study 01-1 and Case Study tips.   This post has been updated to cover what you need to learn in the context of value investing and the role of case studies. Revision date: 18 Oct 2020

If you have come to this blog hoping to get weekly tips on which stocks to buy – sorry, you have the wrong blog.

OK, the case studies do provide you with a pretty good idea of whether the featured companies should be high in your buying list.

But I hope that is not the main reason you are here because, with one case study per month, I will probably be featuring only 12 companies per year.
  
What can you get from this blog?
  • If you are new to investing, I hope to shorten your learning time by helping you develop the 3 skills required to be a successful value investor
    • How to analyze companies
    • How to value them 
    • How to mitigate risk
  • If you are an experienced investor, I hope to provide insights for the featured companies.

To help you get the most value from the blog I have structured the blog as follows:
  • I have some pointers within the text of the case study, sometimes just to clarify why I am doing a particular analysis. 
  • My case studies are generally 2-parters published 2 weeks apart.  In between, I will have the Case Notes post where I hope to share some insights from the case study. 

Contents

  • What investment students need to know
    • Valuing a business
    • Thinking about prices
    • Value traps
  • What can you pick up from my Case Studies?
    • Business analysis
    • Valuation
    • Risk
  • How to learn from Case Studies
  • Takeaways



Case study


What investment students need to know

Warren Buffett in his 1996 letter to his shareholders said:

“To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these.  That, of course is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”

The Warren Buffett quote above sums up what I will focus on my blog
  • How to value a business 
  • How to think about market prices

Valuing a business

While valuation is a numerical based exercise, you have to ensure that it does not turn out to be number crunching. Use assumptions and projections grounded in reality.

One way to ensure this is to first have a good understanding of the business you are valuing - the company analysis.

However, there are several perspectives when analyzing companies:
  • Management would be looking at ways to improve its operations and/or business direction
  • Creditors would be assessing the risk of extending loans and/or credit to the company
  • Investors would be determining whether to invest

As a minority investor, you have to remember that you are not management. Unless you are an activist investor, you are not likely to decide on how the company operates. 

Your company analysis is thus from the perspective of trying to determine where the business is heading.  Consider the challenges and risks so that you can make some realistic assumptions in your valuation.

What you focus on in the analysis will be different from that of management and other parties. 

Thinking about prices

Thinking about prices

“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”   Warren Buffett

If you are a stock trader, price and volume data are critical information because the focus is on trading pieces of paper. The fundamentals and/or intrinsic values of the companies are not important

But, if you are a value investor, market prices are also important. You are buying and selling based on how the market price compares to the intrinsic values

Both price and value are the two sides of the same coin. Understanding the difference between price and value is the core principle of value investing.
  • While you can get the price of a stock (for listed companies), there are no quoted intrinsic values. In practice, you have to estimate the intrinsic values yourself. 
  • Different investors will have different estimates of the intrinsic value of a company.  Contrast this with the stock price. While the stock price may fluctuate, at any one point, there is one price representing the thinking of the crowd at that time. 
  • Relative value is not intrinsic value. Relative value is assessing the worth of a company by comparing it with its peers. Intrinsic value is based on the company’s fundamentals and is related to the discounted cash flow generated by the business over its life.  So, the market price represents the perceived value by the crowd and is not the intrinsic value.
  • Market price changes very whereas intrinsic value does not change on a day to day basis.

Technically market prices are set by supply and demand.  According to economic theory
  • If there are more buyers than sellers than the price will adjust upwards until we have the situation where the number of buyers = number of sellers
  • If there are more sellers than buyers, the price will adjust downwards until we have an equal number of sellers and buyers

Of course, this is an economic model that works in a freely competitive environment and may not reflect what is happening in the stock market.

I prefer to look at the reasons why people buy or sell.  For every transaction, there are people of opposite sides
  • The buyers are those that expect the price to give up so that they can make money
  • The sellers are those that think they will lose money or that they have made enough as they don’t expect the price to go up in the future. 

So the real question is what drives the expectation.

I believe that it is a combination of sentiments and business fundamentals.  In the short run, sentiments rule while in the long run business fundamentals have more influence.  The challenge is that sentiments are also influenced by fundamentals

This 2 views of what drives stock prices have given rise to 2 investing methods
  • The technical school is those that use price and volume information as a proxy for market sentiments.  These people trade pieces of paper.
  • The fundamental schools have value investors as one good example. These consider investing as being part-shareholder of a company and as such view the business fundamentals as the main driver of value. 
Value traps

Value traps

By its nature, value investing is about 
  • Identifying undervalued companies, 
  • Investing in them and 
  • Selling them when they are overvalued.

The critical components are then 
  • Determining the intrinsic value and 
  • Comparing the prevailing market price with intrinsic value.

That is where value traps come in.

Value traps are companies that while appearing to be cheap, is actually not cheap as there are some fundamental issues with the company. So, if you invest in such a company you will be caught in a value trap as the price will continue to be low.

When you compare price with intrinsic value, there are several possible scenarios
  • The intrinsic value is correctly assessed and with the price below the intrinsic value, the stock is a bargain
  • The intrinsic value is wrongly assessed.  Although the price is below the assessed intrinsic value, the true situation will eventually come to light. When this happens, the price will continue to languish. You have a value trap

You can see that value traps and bargains are the opposite sides of the value investing coin. 

Value traps are part and parcel of value investment. 

The only way you can avoid a value trap is to assess the intrinsic value correctly.

The various case studies are attempts to drive home this point.  


What can you pick up from my Case Studies?

Warren Buffett has referred to his “two courses” several times since the letter. I don’t know whether it is an urban legend but he supposedly mentioned that he would do one case study after another when asked about the “How to value a business” course.

The case study method of learning is the hallmark of the Harvard Business School. The idea is that by using real-life situations, you can gain insights that may be difficult to teach via lectures. 

You learn better from examples. 

Each of my company case studies focuses on 3 issues
  • What is the business of the company and where is it heading?
  • What is the intrinsic value of the business?
  • What are the key risks?
While valuation and risk mitigation are separate subjects covered elsewhere in the blog, they are an integral part of any valuing investment process.

Business analysis

The starting point for any business analysis is to run through the historical Annual Reports. 

I then supplement this with industry insights
  • Competitors Annual Reports are also good sources of such information
  • I also look at industry research

You will notice from the Eksons’ case study that I don’t provide details of the Financial Statements.  But I do rely quite a lot on them to gain information about the current and future financial health of the company. 

The financials are important building blocks but are not the end in themselves.  Think of them as the bricks and cement in a building.  You are interested in the building and not the bricks and cement.

It is not the numbers that are important. It is what is behind the numbers that are more important. 

To do this, I read 
  • The Financial Statements and the accompanying notes, 
  • The Chairman’s Statements and the Management Discussions and Analysis. 

What about Corporate Governance, Risk Management, and Sustainability Statement? I skimped through them if they are motherhood statements. I only pay close attention if they can inform on the long-term prospects of the company eg impact on the business direction, key risks. 

The quantitative analysis is a straight forward part.

It is always the qualitative analysis that is the most challenging.  You are trying to get a picture of 
  • Where the industry is heading, 
  • The prospects of the company, and 
  • Whether management would be able to meet the challenges over the next 10 to 20 years.

I don’t think you can get this with quantitative analysis alone.  

I hope that Part 1 of Eksons have shown that company analysis and valuation is not about being an Excel-king. 

I did not start off with a spreadsheet and you will notice that the focus is on understanding the business ie
  • How does the company make money?
  • Where is it now?
  • How did it get here?
  • Where is it heading?
  • Where does it want to go?

We all have our own approach in trying to get the answers to these questions.  I prefer what I have done in the Eksons case study and will be using this framework in all my case studies. 

I also did not use the conventional SWOT (Strengths, Weaknesses, Opportunities, and Threats) technique in my analysis. I think this is overused and I have seen many SWOT analyses that are not linked to what to do next.

But the main reason I tend to avoid SWOT is that you are analyzing the company to see where it is heading.  You are forecasting the future from an investor’s perspective.  You are not management. 

Unless you are an activist investor, you don’t have much hope of changing the way the business is run or heading.  Yours is the minority shareholders’ perspective. 

I believe that I have provided a framework to enable you to identify the issues in such a way as to help in the valuation process. 

The point is that there are many techniques available from Porter’s 5 Forces, Factors analysis to the BCG matrix.  Each will have its own use and weaknesses. 

It is not the technique that is important.  It is the answers that you want and I will be using a variety of analytical techniques in all my case studies.


Valuation

Valuation

I use 2 main valuation methods to derive the intrinsic value
  • Asset-based where I consider the assets as a store of value.  I rely on the Balance Sheet for this.
  • Earnings-based where the assets are seen as a generator of value. The intrinsic value is the discounted free cash flow generated over the life of the business. I rely on the Profit and Loss and Cash Flow statements for the information required for this.

I also have a host of other valuation techniques to help me triangulate the intrinsic values.  These include the Acquirer’s multiple and the Greenblatt “Magic Formula”.

I extract all the information for these above valuations from the company’s financial statements.  

While I do not show the financial information specifically in my case studies, I have 
  • A spreadsheet with at least the past 12 years financials for each company.
  • A financial model that extracts the relevant statistics for my financial analysis and valuation. 

The chart below provides a snapshot of such an analysis. 

Financial analysis worksheet example

Risk

I view risk as a permanent loss of capital and my risk management approach is to
  • Identify all the possible causes for any permanent loss of capital
  • Assess the threats in terms of the impact and the likelihood of it occurring
  • Adopt a host of risk mitigation measures 

You can see that you need to have a strong understanding of the business in order to assess the risks.

In other words, the company analysis serves two purposes
  • Ensure that your assumptions about the prospects of the company using in the financial model are realistic
  • Enable you to identify the threats and hence take the appropriate risk mitigation measures

Of course, some of the threats are related to the investment process and my behavior while others are related to the business itself.  

To handle the latter, I cover the key risks in my company analysis as shown in the Ekson’s case study. 


How to learn from Case Studies

My investment case study is a description of a company’s business, its prospects, risks, and my estimate of the intrinsic value.

It recounts events or problems in a way that so that you can learn from their complexities and ambiguities. 

There are two ways for you to learn from the case study
  • Passively by merely looking at how I have analyzed and valued the company.  You can use this as a template for your own analysis and valuation
  • Actively by trying to analyze and value the company yourself before reading the case study. Then compare your analysis and valuation with mine. 

If there was a formal classroom setting, there would be an opportunity to discuss the analysis and valuation with the class.  You would have the chance to reflect on how your analysis and valuation might change as a result of the class discussion.

Unfortunately, without a classroom setting, the next best alternative is to do the comparison yourself. 

It is obvious that for the case study to be useful, you must have the necessary knowledge first. Then the case study will then help you to understand what you have learned. More importantly, it will help to develop your skills in 
  • Qualitative and quantitative analysis
  • Dealing with ambiguities

It should be remembered that to develop the necessary investment skills you need both knowledge and practice.  Case studies provide one way to see what you have learned being applied in a real-world setting. 

The alternative to case studies is a simulation or paper transactions. But these are stories for another post.

Takeaways

  • I hope the Eksons case study has provided you with a framework to analyze companies.
  • The starting point in valuing a company is to understand its business. "I am a better investor because I am a businessman, and a better businessman because I am no investor." Warren Buffet
  • If you are new to investing, I suggest that you read the 3 Fundamentals posts and then follow me on all the Case Studies and Case Notes. I think it would be a good idea once you have gone through 3 or 4 case studies to re-read the Fundamentals.  I am sure you will pick up more points in the second round of reading.
  • Even if you are an experienced investor, I hope that Case Studies will give you some fresh insights.  I would have done a good job if I have provoked you to challenge my conclusions.
  • The key insight is that value traps and bargains are the opposite sides of the value investing coin. One of the goals of the case studies is to learn how to distinguish which side of the coin a particular company is on. 




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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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