Chetan Parikh, Director, Capitalideasonline.com
This book would rate pretty high on my list of recommended reading material for value investors. There are some insightful chapters on how to think like a value investor, business and industry assessments, price and value assessments, identification of catalysts and their effectiveness, understanding and computing the "margin of safety", identifying different types of investment opportunities and pointers on generating value ideas and building an independent portfolio.
The author is a practitioner who worked under Michael Price, and has examined many opportunities such as:
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Pure value opportunities, such as identifying significantly undervalued companies or well-run cyclical companies at the bottom of their cycles. Event-driven opportunities, such as corporate restructurings and spin-offs.
Bankruptcies, mergers and acquisitions.
The value investing equation, which should be the mindset of the value investor is:
Good Business + Excellent Price = Adequate Return Over Time
Investors need to understand the need for emotional discipline, the lack of which is exhibited in the following characteristics:
* We often believe what we want to believe, and tend not to take into account what the facts dictate.
* Short on courage; we at times lack conviction about our own work. We are often too short-term oriented.
As the author states: "Believing what we want to believe, due to self-denial or overconfidence, is a category into which many investors fall. Overconfidence can be very dangerous for any investor because it often causes rational investors to think irrationally."
There are seven fundamental beliefs that the author feels are important for value investors:
1. The world is not coming to an end, despite how the stock market is reacting.
2. Investors will always be driven by fear and greed, and the overall market and stocks will react accordingly. This volatility is simply the cost of doing business.
3. Inflation is the only true enemy. Trying to predict economic variables and the direction of the market and the economy is a waste of time - focus on businesses and their values, and remember Belief #1
4. Good ideas are hard to find, but there are always good ideas out there.
5. The primary purpose of a publicly traded company is to convert all the company's available resources into shareholder value. As shareholders, your job is to make sure that this happens.
6. Ninety per cent of successful investing is buying right. Selling at the optimal price is the hard part.
7. Volatility is not risk; it is an opportunity. Real risk is an adverse and permanent change in the intrinsic value of a company.
The author believes that the value investor's framework for considering investment opportunities is summarised through the following five key questions:
1) Is this a good business run by smart people?
2) What is this company worth?
3) How attractive is the price for this company, and what should I pay for it?
4) How realistic is the most effective catalyst?
5) What is my margin of safety at my purchase price?
Business assessments allow the value investor to focus on a full range of relevant business and industry issues that affect the value of an enterprise. Value investors then perform fair value assessments that allow them to establish a range of prices that would determine the fair value of the company, based on measures such as normalised free cash flow, break-up, take-out, and/or asset values.
Exit valuation assessments provide rational "fair value" target prices and give the upside opportunity from current stock prices. Price assessments allow the investor to fully understand the price at which the stock market is currently valuing the company. The price of a company's shares could be cheap for permanent reasons. Price assessment also provides the reasonable price that one would pay for the company.
Catalyst identification allows for thinking through how the gap between the current price and what value investors think it is worth is going to be bridged. Not all catalysts are created equal - they vary in the degree of potency. In cases where the catalyst is delayed or ineffective, the value investor's margin of safety assessment, prior to the purchase, becomes important.
There is a major discussion on the valuation tools that an investor can use.
According to the author, to get a company's fair value, the value investor triangulates a valuation. Triangulation involves using three of the best valuation tools for that particular business. The three broad categories of tools are 1) comparison-based 2) asset-based and 3) transaction-based.
In each of these approaches, using "multiples" is the most common tool that investors use. The common comparison-based tools are P/E, P/B, EV/EBIDTA, P/S and EV/R.
Asset-based tools are based on a DCF analysis and sum-of-the-parts metrics. Transaction-based tools depend on the values that a firm's assets could go for based on recently concluded deals.
The "Margin of Safety" is the support mechanism for a company's stock.
It is the safety purely based on the value of assets. The two quantifications here are 1) liquidation value 2) replacement value.
Comparing asset value and the value of the company as an on-going resource converter can give many insights into the company. For example, if the asset value is greater than what the company is worth, then it can be assumed that it is a direct result of poor management or a bad industry. Value investors believe that if they purchase shares of a company below its asset value, they have a very good chance of making money. Other ways rely on "taking private" valuations, dividend yield factors and historical valuations.
For the value investor the risk relatioship is as follows:
Total Investment Risk = Basic Business Risk + General Market Risk
The investment opportunities that the author discusses with case studies are:
1. Modest/slow growth
2. High growth
3. Event-driven
4. Cyclical
5. Temporarily depressed
6. Hybrids and what to avoid
7. Value traps
The book also gives some insights into idea generation and portfolio construction.
Title: The 5 keys to value investing
Author: J Dennis Jean-Jacques
List Price:$24.95